256 1 RP-1999-0034 2 3 4 IN THE MATTER OF ss. 19(4), 57, 70 and 78 of the 5 Ontario Energy Board Act, 1998, S.O. 1998, c. 15, 6 Sched. B; 7 8 9 AND IN THE MATTER OF an Ontario Energy Board 10 Staff proposed Electricity Distribution Performance 11 Based Regulation Handbook 12 13 14 Hearing held at: 15 2300 Yonge Street, 25th Floor, Hearing Room No. 1, 16 Toronto, Ontario on Wednesday, September 22, 1999, 17 commencing at 0900 18 19 20 21 22 23 TECHNICAL CONFERENCE 24 25 VOLUME 2 26 27 28 257 1 APPEARANCES 2 JENNIFER LEA/ Board Counsel, Board 3 MIKE LYLE 4 ROBERT WARREN Consumers' Association of 5 Canada 6 ROBERT POWER/ Hydro Mississauga, London 7 SEABRON ADAMSON Hydro, Oshawa PUC, Sarnia 8 Hydro, St. Catherines Hydro, 9 Whitby Hydro, Petrolia PUC, 10 St. Thomas PUC, GPU Electric 11 Inc./GPU Services Inc. and 12 Collingwood PUC, ENERConnect 13 JACK GIBBONS Pollution Probe 14 PAUL FERGUSON/ Upper Canada Energy 15 DR. C.K. WOO/ Alliance 16 PETER FAYE/ 17 DAVID WILLS 18 MARK RODGER Toronto Hydro 19 RICHARD STEPHENSON Power Workers Union 20 DAVID POCH Green Energy Coalition 21 ELIZABETH DEMARCO Lindsay Hydro, Flamborough 22 ZIYAAD MIA Coalition of Distribution 23 Utilities 24 ROGER WHITE ECMI 25 TOM ADAMS Energy Probe 26 MAURICE TUCCI MEA 27 STEPHEN CARTWRIGHT Enbridge Consumers Gas 28 BILL HARPER Ontario Hydro Networks 258 1 APPEARANCES (Cont'd) 2 KEVIN BELL Great Lakes Power 3 GERRY DUPONT Nepean Hydro 4 RICHARD BATTISTA Union Gas Limited 5 BRIAN McKERLIE Municipality of Chatham-Kent 6 MICHAEL JANIGAN Vulnerable Energy Consumers 7 Coalition 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 259 1 Toronto, Ontario 2 --- Upon resuming on Wednesday, September 22, 1999, 3 at 0900 4 MS LEA: Just before we begin, can I 5 ask for a show of hands of how many folks still have 6 questions for this panel. It turns out that one of the 7 consultants here, also, this is his last day. So we 8 are trying to fit in all kinds of people who have other 9 commitments. 10 Mr. McKerlie has questions. 11 Mr. Harper has questions. Mr. Grieve has questions 12 also. 13 UNIDENTIFIED SPEAKER: Seabron 14 Adamson. 15 MS LEA: Oh, Seabron Adamson, yes, I 16 knew that, Mr. Adamson. 17 MR. ADAMSON: We didn't get there 18 yesterday. 19 MS LEA: And the gentleman from 20 Nepean. I'm sorry, sir, I don't know your name. 21 That's fine. 22 Anyone else? All right. Thanks. 23 I should allow, also, Mr. McKerlie to 24 make an appearance; I kept forgetting to do that. 25 Mr. McKerlie, did you want to 26 introduce yourself, spell your name and say where you 27 are from, please. 28 MR. McKERLIE: Yes, thank you. 260 1 It's Brian McKerlie, M-C-K-E-R-L-I-E, 2 from the Municipality of Chatham-Kent. 3 MS LEA: Thank you very much. 4 MR. JANIGAN: I wonder if I should 5 enter an appearance, as well. 6 Michael Janigan, for the Vulnerable 7 Energy Consumers Coalition. 8 MS LEA: Thank you, Mr. Janigan. 9 Anyone else? All right, then. 10 There being no further preliminary 11 matters, Mr. Adamson, please go ahead. 12 RESUMED: JUDY KWIK 13 RESUMED: FRANK CRONIN 14 RESUMED: MIKE KING 15 MR. ADAMSON: Thank you. 16 Let's see if I can talk into the mic. 17 I guess I would like to sort of kick 18 of returning, briefly -- and I will try to be 19 relatively brief on the contributed capital issue. 20 Just to sort of kick back to where we 21 were yesterday afternoon, I believe you said, yesterday 22 afternoon, that in your TFP study you had attempted to 23 measure capital deployed by each LDC in your sample and 24 that this measure of capital included all capital, 25 whether or not it was contributed by customers. 26 Is that right? 27 MR. CRONIN: Yes. 28 MR. ADAMSON: Okay. Can you briefly 261 OEB Panel 1 restate the reasons why you thought it was important to 2 use a measure that included customer contributed 3 capital? 4 MR. CRONIN: We wanted to reflect 5 what had been used historically. 6 MR. ADAMSON: Why was that important? 7 MR. CRONIN: Well, we are trying to 8 measure the inputs into the production process. 9 MR. ADAMSON: Do you think, for the 10 purposes of setting economically efficient rates, that 11 it is important that measures of capital be used that 12 include all the capital which has been historically 13 employed? 14 MR. CRONIN: I guess I would answer 15 yes, with the proviso that we don't have a situation 16 where the fact that capital was free induced some 17 entity to employ too much capital. 18 MR. ADAMSON: Right. So we may have 19 a rather poorly productively efficient situation where, 20 in effect, the mixture of factor inputs may be a bit 21 skewed because of historical decisions or historical -- 22 potential misallocations -- 23 MR. CRONIN: Right. 24 MR. ADAMSON: -- due to the use of a 25 kind of an arbitrarily low cost of capital? 26 MR. CRONIN: Yes. 27 MR. ADAMSON: Okay. Well, I 28 certainly agree there. 262 OEB Panel 1 In the TFP study, in Section 3.0, you 2 defined the capital price index which included the 3 Canadian long bond rate as a measured opportunity cost 4 of capital and I believe you said that that was clear, 5 that the Canadian long bong rate, during that period, 6 had been -- and now -- had been quite different than 7 the historical returns on equity -- 8 MR. CRONIN: Yes. 9 MR. ADAMSON: -- of the utilities? 10 Okay. 11 If the prices for electricity are set 12 too low on the basis of cost reflectiveness -- which we 13 might take as a measure of long-run marginal costs, for 14 example -- could that have any impacts on the efficient 15 consumption of electricity? 16 MR. CRONIN: Yes. 17 MR. KING: Just to expound, it would 18 probably mean that folks would overuse electricity. 19 MR. ADAMSON: Right. I think that's 20 a kind of standard argument. 21 In the White Paper, on page 22, it 22 states that the LDCs are, in effect, to be corporatized 23 and that they are, quote: 24 "-- required to be operated on a 25 business-like basis, as were 26 electrical utilities in New 27 Zealand, Australia, Norway and 28 many other countries." 263 OEB Panel 1 (As read) 2 That's just a line, subject to check. 3 To your knowledge, did the process of 4 corporatization of network industries in those 5 countries, in any of those countries, involve the 6 revaluation of network assets, particularly 7 distribution assets or electric transmission assets? 8 MR. KING: I'm sorry. What were the 9 countries, again? 10 MR. ADAMSON: New Zealand, Australia 11 and Norway. 12 MR. KING: I'm not specifically 13 familiar with whether there were revaluations in those 14 countries. 15 MR. ADAMSON: Can you think of other 16 countries which have undergone a similar 17 corporatization process and/or privatization process, 18 which may have undergone, I think of it as a 19 fundamental economic revaluation of network assets? 20 MR. KING: Well, it depends upon what 21 you mean by revaluation. If you were to, say, take the 22 case of England and Wales, where the RECs were 23 privatized, in the run-up to privatization of the 24 industries there were certain concessions that were 25 made in order to affect their valuation. I think that 26 would be one case. 27 But as to fundamentally affecting 28 their valuation, I'm not sure exactly what you mean. 264 OEB Panel 1 MR. ADAMSON: I guess I'm interested 2 in, effectively -- and this probably just moves on to 3 the next point. In the TFP study, you note that the 4 standard utility accounting of capital costs is based 5 on a book valuation -- i.e., historical valuation -- 6 and sales to reflect changing asset prices over time is 7 a measure of input. I think that's an economic 8 statement that we can all agree on. 9 Do you think that the same problem 10 may affect the rate base and the historical cost of 11 assets of distribution assets on which rates have been 12 set for distribution in Ontario? 13 MR. KING: Can we confer for a sec? 14 MR. ADAMSON: Absolutely. 15 --- Pause 16 MR. KING: I think there's a mixture 17 between economic principle and regulatory 18 implementation which is imbedded in your question. 19 From a pure economic point of view, 20 you would wish to represent the opportunity cost of the 21 employment of that capital; which means that it should 22 be based upon some sort of market value sort of basis. 23 However, there are few regulatory -- 24 there are few jurisdictions that I know of that embrace 25 such a concept, mainly because regulation is generally 26 applied in monopoly situations and the precepts of past 27 regulatory process have relied much more on imbedded 28 cost or book value of the capital deployed. 265 OEB Panel 1 So, from a perspective of "first 2 best" pricing signals, I would agree with your premise, 3 but from the point of view of regulatory practice, I 4 don't believe that any jurisdiction has embraced those 5 sorts of concepts, that I'm aware of. 6 MR. ADAMSON: So, to your knowledge, 7 sort of potentially relevant comparable jurisdictions 8 are typically all relying on an historical cost 9 accounting approach; what we might call an imbedded 10 cost approach? 11 That's sort of an Americanized term, 12 I think, in regulation. 13 MR. KING: Right. Now, it very well 14 may be the case that there was some revaluation in the 15 other countries; I'm just not aware of it. 16 MR. ADAMSON: Right. But you would 17 stand by the statement that, effectively, the HCA-based 18 accounting or distribution capital assets may not 19 reflect changes in asset prices over time? 20 MR. KING: Yes. 21 MR. ADAMSON: Thank you. 22 I would now like to move back to some 23 of the issues I think we were covering over yesterday 24 afternoon on setting the base productivity factor and 25 the differing abilities of LDCs to make cost savings, 26 given their potential starting positions. 27 In all honesty, Dr. Cronin made some 28 comments which I simply didn't get down, or didn't get 266 OEB Panel 1 down in a way that I felt I could quote back, whether 2 he expected potentially everyone would be able to make 3 relatively the same level. 4 I don't want to put any words in your 5 mouth. I was just wondering if you could kind of kick 6 us back off on that train of thought. 7 MR. CRONIN: I think my statement was 8 that I thought that the firms who were in fact more 9 efficient would be the ones who benefited most from the 10 PBR as it has been designed. That has to do partly 11 with the fact that they would be presumably more 12 efficient, in part due to management and, secondly, 13 that they would probably have a higher probability of 14 moving to the market based rate of return. 15 If you looked at in terms of who is 16 going to benefit over the next two or three years, I 17 think it will be the efficiently run firms because they 18 are efficient and because they would have better 19 management and because they would have an ability to 20 move their rates up to the ceiling. 21 MR. ADAMSON: Okay. Let's kind of 22 separate those eggs. First off, starting with the 23 ability to move to the market based rate of return, 24 didn't all the LDCs have the opportunity to move to a 25 market based rate of return? 26 MR. CRONIN: Well, they do. I'm 27 talking in this regard -- 28 MR. ADAMSON: You are saying 267 OEB Panel 1 effectively that potential rate increases might be such 2 that they might not want to. 3 MR. CRONIN: That's right. 4 MR. ADAMSON: As a kind of a policy 5 constraint. 6 MR. CRONIN: That's right. 7 MR. ADAMSON: But they will have the 8 freedom to do so. 9 MR. KING: It's not so much that 10 there's a policy constraint. It's more the 11 acceptability with the public. 12 MR. ADAMSON: Right. Well, the 13 municipality may decide that that's not the way to go. 14 MR. KING: Or the ratepayers may 15 protest to the levels where one is not able to actually 16 implement the rate increase. If you think about those 17 more efficient utilities, because the overall level of 18 the change that is $10 per household as opposed to 24 19 less efficient firms, the $10 may be more acceptable 20 than a $20 change. The total magnitude of the change 21 is less. 22 MR. ADAMSON: Okay. So at least this 23 section of the argument is based on a suggestion that 24 the more efficient ones are lower cost today. They 25 already have lower costs built into their rates through 26 the kind of starting point from the unbundling process 27 and, therefore, they have a little more kind of 28 headroom to go up on. 268 OEB Panel 1 MR. KING: They do because they can 2 make arguments comparing their performance to other 3 utilities and suggest that they are more deserving of 4 that rate change. 5 MR. ADAMSON: But subject to the 6 interaction of the LDC on its municipal shareholders 7 and obviously whatever pressures apply to that which is 8 somewhat outside, I would argue, the scope of 9 proceeding here. The mechanism as constructed in the 10 draft handbook allows all the LDCs to decide to move to 11 market based rate of return if they see fit. 12 MR. KING: That's correct. 13 MR. ADAMSON: Let's sort of separate 14 this out, whether they decide they want to or not. 15 That's really effectively outside the control of really 16 all of us, I think, sitting here. It effectively is a 17 responsibility delegated to the municipal shareholders 18 to decide. 19 I would like to return to 20 Dr. Cronin's argument about due to management. Again, 21 without sort of putting words in your mouth, you think 22 that effectively the utilities that are most efficient 23 now will -- that's almost like a signal that they 24 probably have better management and that a better 25 management team might be better placed to make more 26 cost savings in the future. Is that the -- 27 MR. CRONIN: To the extent that 28 management has induced the efficiencies. It's like 269 OEB Panel 1 taking a poorly run sports team and trying to 2 reorganize it overnight and suggesting that they can 3 transform the whole mechanisms of how they work 4 together. 5 Businesses that are better managed I 6 think will perform better for the next two or three 7 years. 8 MR. ADAMSON: I'm trying to recreate 9 the linkage -- I'm trying to understand the linkage in 10 your mind between utilities that seem -- some of which 11 might seem like starting at a higher level of 12 efficiency. Are you suggesting that that is probably a 13 signal that those are the ones that are better managed 14 already? 15 MR. CRONIN: Better management is 16 part of why they are more efficient. 17 MR. ADAMSON: And what might the 18 other components be? 19 MR. CRONIN: It could be that some 20 just have more beneficial characteristics. 21 MR. ADAMSON: Right. So there may be 22 some exogenous factors. 23 MR. CRONIN: Yes. 24 MR. ADAMSON: Let's sort of take 25 those to one side because we really don't have any 26 basis to assess this I don't think at this point. 27 There may all sorts of factors, that 28 "I have the best service territory in Ontario that I 270 OEB Panel 1 can always serve better than anyone else". Let's kind 2 of take those over to one side. I think those are 3 somewhat -- (a) we don't have a way of measuring that 4 and (b) that's a problem not under anyone's control. 5 We might think that the most 6 efficient utilities right now probably have better 7 management. That's at least one factor that probably 8 got them there. 9 MR. CRONIN: It's one factor. 10 MR. ADAMSON: In the future, will the 11 municipal shareholders under the commercialization 12 framework be required to stick with their existing 13 management? 14 MR. CRONIN: Not necessarily. 15 MR. ADAMSON: So management is really 16 kind of an input parameter. It's not a sort of a 17 completely exogenous parameter. 18 MR. KING: Dynamically it can change. 19 MR. ADAMSON: It can change. 20 MR. KING: Statically it's difficult 21 for it to change. 22 MR. ADAMSON: So if I started with 23 one of these least deficient, hypothetical least 24 deficient utilities, LDC "X", and it looks quite 25 inefficient now. We will forget any potential changes 26 due to service territory. I might think that it is 27 probably inefficient, at least partly due to relatively 28 poor management, but it potentially has some quite nice 271 OEB Panel 1 cost savings there. 2 I would like to kind of explore a 3 little bit some of the -- we have kind of two factors, 4 I think, kind of contemplated in your argument. You 5 know, that everyone should be able to do some the same. 6 We may have some that are kind of starting at a 7 relatively poor basis. 8 If you want to have a little chat, 9 okay. That's important. 10 Some are starting from a relatively 11 poor position in terms of their starting efficiency, 12 but we think that's probably a signal that they have 13 relatively poor management. 14 MR. CRONIN: Partly. 15 MR. ADAMSON: It may at least be a 16 factor. 17 MR. CRONIN: Yes. 18 MR. ADAMSON: We may also think that 19 some are quite likely to be substantially more 20 efficient and maybe that's a sign they have good 21 management from day one. I would like to sort of 22 separate out the management point for a moment. I 23 think we will come back to that in a bit, in a second. 24 If I could put in any management team 25 into any of these companies, and we certainly realize 26 there's a certain inertia and things in all of these 27 companies, but if management effectively could be 28 dynamically changed, Mr. King suggests, are there 272 OEB Panel 1 companies that are simply starting from a different 2 point, a different efficiency point, that I might 3 believe are relatively easier to make cost savings from 4 than others? 5 MR. CRONIN: I think, as we have 6 heard some coaches describe, "I can take my team and 7 beat you" or "take your team and beat you", I think 8 there are managers or management teams which innately 9 are better. 10 MR. ADAMSON: The real question is: 11 Are there teams that start in better places than any 12 others? 13 MR. CRONIN: There may be. 14 MR. ADAMSON: Yes. 15 MR. CRONIN: Then the issue is how 16 long would it take a new team to come up to speed. 17 MR. KING: But conceding your point, 18 there are most likely firms in this province who have 19 different levels of technical efficiency and as a 20 result they are at -- you know, I suspect that there 21 are some folks in the audience who are thinking about 22 M&A strategies and they are trying to figure out which 23 ones to buy. 24 MR. ADAMSON: Right. Now, excluding 25 again the management issue, because in my world I am 26 potentially changing that although I certainly 27 understand there is -- and I agree with Dr. Cronin's 28 point -- a certain amount of time that is required to 273 OEB Panel 1 come up to speed on that. 2 If you were thinking about these M&A 3 strategies -- I know you have been involved in the M&A 4 world -- what parts of companies might become 5 attractive in that world? 6 MR. KING: I think the ones that are 7 probably potentially the most attractive are the ones 8 where the greatest efficiencies can be brought out in 9 the shortest amount of time. That means that basically 10 the management structure is not an inhibitor being able 11 to achieve those strategies through some sort of 12 acquisition strategy. 13 MR. ADAMSON: What type of 14 companies -- we agree we are kind of looking for a 15 "bang for the buck" argument about the ability to make 16 the most significant cost savings from the effort we 17 are going to put in as an acquirer. 18 How might I identify what companies 19 those are? 20 MR. KING: To continue your point, 21 there might be some way of thinking about comparative 22 efficiency of the various entities, but layered on top 23 of that one has to look at the organizational culture 24 and to be able to assess whether in the short run -- is 25 it a short run proposition to change the enterprise or 26 a long run proposition to change the enterprise? 27 After all, we all know the story of 28 Chainsaw Al Dunlap and Sunbeam, right? I mean, you 274 OEB Panel 1 know, this guy has turned around 15 companies and he 2 goes to Sunbeam and he gets to a company that is so 3 sick culturally that he wasn't able to transform it. 4 MR. ADAMSON: Right. So there is a 5 compilation kind of management culture and corporate 6 culture issues, plus there is the question of literally 7 given that Company A and Company B, or in this case LDC 8 A and LDC B, are starting at such different points that 9 some of those may be easier to make credence out of 10 than the other. 11 MR. KING: Right. 12 MR. ADAMSON: And nothing else 13 starting with staffing levels. 14 So I understand you haven't conducted 15 any of -- I think we heard yesterday you haven't 16 conducted any kind of co-op LDC efficiency analysis? I 17 think that is an appropriate characterization. 18 Is that right? 19 MR. KING: That's right. 20 MR. ADAMSON: Have you conducted even 21 any kind of simple partial factor productivity analysis 22 across the LDCs on comparative efficiency like sort of 23 the normal ratios and even simple statistics? 24 MR. CRONIN: Nothing comprehensive. 25 We have looked at data on numbers of employees, that 26 type of thing; but again many of the physical 27 benchmarks that you might use are incomplete. 28 MR. ADAMSON: Right, yes. I think 275 OEB Panel 1 the capital efficiency questions are probably the most 2 difficult ones. 3 MR. CRONIN: So if you look at the 4 partial, you are back to the same problem of missing 5 the other pieces of the picture. 6 MR. ADAMSON: Right. Although 7 sometimes even partial factor productivity measures are 8 at least sort of illustrative of broad trends. 9 What was the sources? You said you 10 had looked at sort of customers per employee data or 11 something? 12 MR. CRONIN: Well, what was in the 13 data we collected. 14 MR. ADAMSON: Oh, within the data 15 that you looked at. 16 MR. CRONIN: Yes, we didn't look at 17 any extra data. 18 MR. ADAMSON: Okay. Subject to 19 check, would you accept that the very simple labour 20 productivity statistic which is on a kind of a 21 customers per employee basis, which was collected I 22 believe by the MEI in 1997 for a set of LDCs, showed a 23 fairly significant variation across the sample of 24 reporting utilities where the average is approximately 25 410 customers per employee but at a standard deviation 26 of 154? 27 MR. KING: It seems in the range 28 of -- 276 OEB Panel 1 MR. ADAMSON: It is about the range 2 of possibility. I mean, we all know the problems that 3 use of such comparative statistics entails because we 4 don't capture all the trade-offs, as Dr. Cronin says, 5 but really at this point we don't have anything more 6 sophisticated to fall back on. 7 If it happened to be that other 8 things were equal and it wasn't due to environmental 9 effects that we haven't been able to measure, do you 10 believe that an LDC with 600 customers per employee 11 might have more difficulty making the same percentage 12 cost savings over the three-year period than one 13 starting with 300 customers per employee? 14 MR. CRONIN: Again, I think we are 15 back to the same issue. We really don't know the 16 comparative state. We don't know the management. We 17 don't know what factors are being considered to 18 incorporate the production process. 19 MR. KING: It also presumes that all 20 customers are equal. 21 MR. ADAMSON: Certainly and they may 22 be. I made a very simple attempt to try to capture 23 roughly equivalent samples, but of course that is 24 always relative and limited with an ability to do a 25 sort of formal DEA type of analysis or something more 26 sophisticated. 27 But I believe, Mr. King, you agreed 28 that there probably are some LDCs who are starting off 277 OEB Panel 1 at an initial efficiency point that would make it 2 relatively easier for cost savings to be achieved than 3 other LDCs in the province? 4 MR. KING: Just a second. Can I have 5 a conference? 6 --- Pause 7 MR. KING: My answer, Mr. Adamson, is 8 yes, I think I would concede that point but, as 9 Dr. Cronin counsels me, we can't identify specifically 10 who those are. 11 MR. ADAMSON: Is it possible that 12 some rather perverse incentives might be created under 13 the draft PBR plan if in fact the most efficient may 14 find it more difficult to profit starting out as 15 compared to the least efficient? 16 MR. KING: I think there is an 17 implicit assumption in your question which is that the 18 most efficient are the ones who have the toughest time 19 being able to instill additional efficiencies into 20 their enterprise. If that premise is true, I would 21 agree with you. However, I am not sure that Dr. Cronin 22 and I agree that that is necessarily -- that premise is 23 necessarily accurate. 24 MR. ADAMSON: That assessment is 25 based on -- 26 MR. KING: Again, the example that 27 Dr. Cronin alluded to and that I alluded to before that 28 it is not just an issue of technical efficiency; it is 278 OEB Panel 1 also an issue of management culture. Often those who 2 are most able to achieve efficiencies are those who 3 instill in their organization the constant pursuit of 4 efficiency and efficiency opportunities. So they may 5 be the most efficient but they also may be the most 6 productive. 7 MR. ADAMSON: Right. I think we have 8 been down that track. 9 So the system, I think to take it one 10 stage further, we will at least say doesn't -- they 11 still may be able to do it given the fact that there is 12 a strong correlation with them starting with a better 13 management team. 14 Does it reward having strong 15 management today? 16 MR. KING: Does the PBR mechanism? 17 MR. ADAMSON: Yes. 18 MR. KING: I believe so. If strong 19 management are those who can achieve high productivity 20 and higher returns, and they are also because of their 21 strength of their management amongst the most 22 efficient, then they have the ability, as Dr. Cronin 23 asserted earlier. They have a higher likelihood of 24 being able to go to a market-based rate of return and 25 they have a greater probability of being able to drive 26 efficiencies into -- 27 MR. ADAMSON: Well, everyone has the 28 ability to get a market-based rate of return. 279 OEB Panel 1 MR. KING: Everyone has the ability. 2 Not everyone may have an equal probability of being 3 able to get there. That's the first one. 4 MR. ADAMSON: But that is exogenous 5 to the plan. That is, in effect, not under the control 6 of the plan. 7 Is that a decision for -- is that 8 decision framework encapsulated in the plan or is that 9 effectively a -- 10 MR. KING: Everyone has the right 11 under the plan -- 12 MR. ADAMSON: Everyone has the right. 13 Okay, thank you. 14 MR. KING: -- to go to a market-based 15 rate of return. 16 MR. ADAMSON: Yes. 17 MR. KING: However, the plan has 18 certain -- 19 MR. ADAMSON: I have heard and agreed 20 with the previous statement, but everyone does have the 21 right. 22 Are you familiar with the sections of 23 the White Paper and Bill 35 regarding commercialization 24 of the LDCs and amalgamations and potential sales? 25 MR. KING: I believe that Dr. Cronin 26 and I have read them, although not recently. 27 MR. ADAMSON: So we might hypothesize 28 that an acquirer, say coming from outside the province 280 OEB Panel 1 or coming from outside of the industry, might face a 2 set of trade-offs -- if we were doing this hypothetical 3 M&A exercise which we discussed earlier -- between 4 trying to identify that better management team which, 5 after all, could potentially be used to run more than 6 one of these businesses, and looking for those easy 7 cost savings, looking for the fat dues which might be 8 sitting out there somewhere. 9 MR. CRONIN: Again, I think it is 10 partly an issue of your approach to acquisitions, your 11 risk preferences and the fact that there is no dataset 12 that exists that actually tells someone "here is a 13 ranking of the most efficient to the least efficient 14 firms in the province". 15 So someone coming in is going to be 16 faced with the issue of -- and even someone in the 17 province, although there may be intuitive beliefs about 18 who is efficient and who isn't, you are still facing 19 this data problem. 20 MR. ADAMSON: Well -- 21 MR. KING: And I think one other 22 thing -- 23 MR. ADAMSON: I agree there is a 24 potential data problem, but perhaps -- and we don't 25 know that perhaps acquirers may be very good at coming 26 to intuitive results on what the comparative efficiency 27 is, even from quite simple partial measures. 28 MR. KING: That may be true. 281 OEB Panel 1 MR. ADAMSON: Businesses tend to make 2 those types of judgments quite often, in my experience. 3 MR. KING: Sure, they make those 4 judgments quite often and they are quite often wrong, 5 which is why M&A -- 6 MR. CRONIN: As academic research has 7 demonstrated, in over half the time mergers fail to 8 succeed, which speaks of the -- 9 MR. ADAMSON: Yes. We might agree 10 that -- 11 MS LEA: One at a time, please. 12 MR. ADAMSON: -- from an acquirer 13 coming in -- 14 MR. CRONIN: If I just can elaborate 15 on that. 16 MS LEA: I'm sorry, gentlemen. You 17 have to speak one at a time because you have to get 18 your voices on tape. 19 MR. CRONIN: I wasn't quite through. 20 If you look at the issue of mergers, 21 which I think is an interesting issue, and you look at 22 the experience over the past 30 years from an 23 industrial organization perspective, there have been 24 dozens of studies from financial departments at 25 universities evaluating their success. 26 Here you have -- in fact, we have 27 seen in the States just recently two, if not three, 28 explosive mergers involving McKesson HBOC and Cendant, 282 OEB Panel 1 both of which exploded after the merger because the 2 acquiring firms failed to do appropriate due diligence, 3 and this is after they hired teams of accountants and 4 had full disclosure in these single transactions. 5 So you have a history of decades of 6 over half the mergers failing, many large mergers 7 recently being utterly unsuccessful, and then to think 8 that someone could come in and just because they are so 9 shrewd they would be able to sort out -- we have heard 10 for over a year about the data problems in the province 11 and the whole issue of having difficulty evaluating 12 comparative efficiency. 13 I think the merger issue is clearly 14 pertinent to this and clearly illustrative of the 15 problem of trying to identify what opportunities are 16 present at any given time. 17 MR. ADAMSON: Yes, I agree to -- I 18 can't disagree with that. 19 I think my interest, however, is more 20 on the kind of design of the mechanism and not the 21 difficulties of the gentleman from the investment 22 banking industry. It seems to me that a mechanism that 23 gives the same price cap to all regulated entities, 24 whatever their starting level of efficiency, 25 potentially rewards those which are least efficient if 26 they can overcome their management problems, which 27 maybe they will be incented to do so, as compared to 28 those which are most efficient. 283 OEB Panel 1 MR. CRONIN: You know, I think -- 2 MR. ADAMSON: Do you agree with that 3 statement? 4 MR. CRONIN: I think what you are 5 stating is possible, and I think what we are stating is 6 possible, and I don't think there is any way -- I think 7 it is partly based on a belief about what the intrinsic 8 nature is of management's ability to continue to 9 improve. 10 Let me just mention, I had 11 mentioned -- and this will be very brief. 12 I had mentioned yesterday afternoon 13 when we were talking the experience in Norway where 14 they had 200 distributors of which the regulator had 15 been regulating that industry for most of the decade. 16 When they went to a PBR plan in 1997 they addressed 17 specifically the issue of the different starting point 18 and they said, in effect, "We can't sort this out. We 19 believe that these differences have been reflected in 20 the cost structure, and absent any other way of 21 disentangling this we are going to apply one 22 X factor -- not a choice in the X factor but one 23 X factor -- to all firms." 24 So that regulator in a similar 25 situation put in a less restricted plan, and what we 26 think is that we have basically given firms more 27 flexibility in dealing with this problem. 28 MR. ADAMSON: Right. That's not -- 284 OEB Panel 1 MR. KING: Mr. Adamson, let's also go 2 with your assertion for a moment, that perhaps the 3 result is that what this plan does is it rewards the 4 most inefficient firms. 5 One can also be somewhat 6 machiavellian in their view of what happens through 7 that sort of scheme. Maybe what happens through that 8 sort of scheme is that management of those firms is 9 incented to dramatically improve their performance and 10 over time those savings will be recaptured on behalf of 11 the ratepayers through some sort of rebasing process 12 and subsequently to perhaps going through some sort of 13 yardstick scheme. 14 MR. ADAMSON: Right. So there may be 15 a capturing of it over time. 16 MR. KING: There may be a capturing 17 of it over time. 18 MR. ADAMSON: Right. 19 MR. CRONIN: Can I agree with your 20 point for a minute? Let me just say that -- 21 MR. ADAMSON: Thank you for that. 22 MR. CRONIN: Let's just for the 23 moment say that what you are asserting is true and you 24 are focusing on the relative inequity across the 25 utilities. One thing that we haven't talked about is 26 what happens to the ratepayers and to the province at 27 large, that is society as a whole. 28 If in fact we designed a plan that 285 OEB Panel 1 got the maximum level of savings out of the industry, 2 which is I think what you are asserting the plan would 3 do, then in fact ratepayers in general, and 4 specifically ratepayers of the least efficient 5 utilities and the province as a whole would be the 6 winners. 7 So I think the conclusion of your 8 assertion is that ratepayers and society in general 9 would be highly benefitted by that conclusion. 10 MR. ADAMSON: Yes. Okay. I think we 11 have beat this horse 12 I would like to move on to the 13 derivation of the productivity factor and return on 14 equity ceiling pairs in Table 4-1. 15 I think from yesterday we got a sense 16 of where the selection (a), the 1.25 per cent number, 17 came from. I think we discussed that yesterday, so we 18 shall not discuss that any more. 19 What analysis was used to develop and 20 support the remaining productivity factor ROE pairs in 21 Table 4-1? 22 MR. CRONIN: In fact, what we were 23 again, I think, faced with was primarily trying to 24 design a plan that was straightforward and simple. For 25 that reason, we basically came up with the design of 26 the plan in the table. 27 MR. ADAMSON: Slipping back to my 28 question, so I understand the objective, the question 286 OEB Panel 1 was: What analysis was used to develop and support the 2 remaining productivity factor return on equity pairs in 3 Table 4-1? 4 MR. CRONIN: There was no formal 5 analysis. 6 MR. ADAMSON: No formal analysis. 7 Okay. 8 So are we to understand that the 9 values in the lower part of the table in Table 4-1 are 10 based on subjective judgment? 11 MR. CRONIN: Again, what we try to do 12 is to look at the experience of the utilities in the 13 province. In fact, there are utilities which have 14 exceeded all values in that table with 75 per cent of 15 the utilities over the past years five years exceeding 16 the default value. So we basically wanted to come up 17 with graduated hurdles, as displayed in the table, 18 looking at small increments in the productivity factor 19 and relatively straightforward increments in the ROE 20 tradeoff. 21 MR. ADAMSON: So did you sort of 22 prepare a histogram of past productivity factors and 23 try to plot those against where people would fall on 24 that table? 25 MR. CRONIN: I guess simplistically 26 we did that. 27 MR. ADAMSON: The design of the 28 mechanism about which you have spoken, of the 287 OEB Panel 1 objectives and the design of Table 4-1, how did you 2 ensure that the return on equity ceilings on the kind 3 of right-hand side compensated the LDCs for the risk 4 that they take on from taking on a higher productivity 5 factor? 6 You commit to a higher productivity 7 factor kind of ex ante, right? 8 MR. CRONIN: Right. 9 MR. ADAMSON: So you sort of take on 10 a higher risk if you take on a higher productivity 11 factor. 12 How did you ensure that the choice of 13 productivity factor and the additional risk were 14 commensurate? 15 MR. KING: It is very difficult for 16 us to be able to assess the risk that anyone entails, 17 is entailed, in selecting a specific productivity 18 factor. After all, we are not the ones who run the 19 business, so we don't know exactly for the industry as 20 a whole what risk they entail from selecting a 21 productivity factor of 1.25 versus some other number. 22 MR. ADAMSON: Okay. 23 MR. KING: In fact, I think the table 24 was designed more from the standpoint of -- the 25 management and shareholder of the entity would have to 26 make their own risk return tradeoff and select the 27 appropriate pair based upon their knowledge of how they 28 had done historically and how they feel that they could 288 OEB Panel 1 do prospectively. 2 MR. ADAMSON: But they are forced to 3 choose from a menu, an a la carte menu, of pairs, 4 right, which -- 5 MR. KING: I would prefer to suggest 6 that it is not forced, but they are given the 7 opportunity to choose. 8 MR. ADAMSON: The menu is defined. 9 There are a set of pairs defined from which they 10 choose. 11 MR. KING: That's correct. 12 MR. ADAMSON: In theory at least, 13 each potential pair would be a viable pair for them to 14 choose from and to reveal information about what they 15 think they can achieve. 16 MR. KING: Yes. 17 MR. ADAMSON: Was there any form of 18 formal or informal analysis to suggest that those pairs 19 matched up on the risk and the return side or again was 20 this a fairly subjective argument? 21 MR. KING: Again, as I had suggested 22 earlier, we don't have a way of assessing risk. 23 We did at least construct a simple 24 pro forma model and run through that pro forma model 25 what would happen if the firm was able to achieve 26 differing levels of productivity for differing levels 27 of pairs that they might wish to commit to. 28 So we did examine what would happen 289 OEB Panel 1 to a firm if they made certain choices. 2 MR. ADAMSON: Give me some insight 3 into why a linear relationship was chosen between those 4 two parameters. 5 I mean, from my reading of Table 4-1, 6 you start at 1.25 and they march up the left-hand side, 7 and there is pretty much a linear relationship between 8 the increases over that base productivity factor and 9 the return-on-equity ceiling. 10 MR. CRONIN: I think there were a 11 number of issues, one being the desire to mitigate 12 significantly bad outcomes. So we wanted to have a 13 ceiling on the potential returns that would be 14 something that stakeholders in general would buy into. 15 Clearly, 15 per cent itself is a 16 fairly rich return in the regulated world. If you look 17 at pipelines and some other utilities, you know, they 18 are in the -- 19 MR. ADAMSON: Yes. 20 I'm not asking about why there is a 21 cap, which I think I understand from your previous -- 22 MR. CRONIN: No. I'm getting to 23 that. 24 MR. ADAMSON: Okay. Sorry. 25 MR. CRONIN: We define the bottom, we 26 define the top or we define the initial starting value, 27 and we wanted to put a ceiling that mitigated the 28 potential for someone to experience windfall profits. 290 OEB Panel 1 So that defined basically the 15 per cent. The rest 2 was basically coming up with graduated steps between 3 that. 4 MR. ADAMSON: The question was: Was 5 there a particular reason why that was a linear 6 relationship or was that just drawing the line between 7 the two points? 8 MR. CRONIN: That just basically goes 9 back to the simplicity issue. 10 MR. ADAMSON: Okay. So it was 11 drawing the line between two points. 12 MR. CRONIN: Right. 13 MR. ADAMSON: Okay. I'm almost done. 14 From what we heard yesterday, it is 15 pretty clear that the base productivity factor was at 16 least partially driven by the results of the TFP 17 analysis. 18 MR. CRONIN: That's right. 19 MR. ADAMSON: Tempered with some 20 experience. 21 MR. CRONIN: Right. 22 MR. ADAMSON: What were the sources 23 of the data for the TFP study? 24 MR. CRONIN: The sources of the data 25 were largely the responses to the questionnaires that 26 were sent out to the utilities in January. 27 MR. ADAMSON: How many LDCs responded 28 in the sample? 291 OEB Panel 1 MR. CRONIN: Again, it varied. We 2 might have had as many as 150 fill out some part of the 3 yardstick data request. There might have been -- I 4 never actually counted what the number of responses 5 were who sent in any data. Some utilities in fact sent 6 in a questionnaire and listed what the head count was 7 in 1997 and nothing else. 8 What we got were several dozen, 9 ultimately 48, responses that we thought we could use. 10 MR. ADAMSON: Okay. 11 Of the ones that you used in your 12 sample -- I think you have mentioned the 48 number 13 before -- those were the ones that had completed 14 everything when they sent it back? 15 MR. CRONIN: No. There were only a 16 handful that had actually completed everything. So we 17 might have gone back, in some cases, seven or eight 18 times to a utility. 19 MR. ADAMSON: Right. So you would 20 kind of iterate with them to keep asking them the same 21 questions until you got a response? 22 MR. CRONIN: Right. 23 MR. KING: I think it's a little more 24 than that. It was working them to convince them that 25 it was worth the effort to send us the data. 26 MR. ADAMSON: Sure. And to get them 27 to understand the question, and so on and so forth. 28 MR. CRONIN: It's kind of, you know, 292 OEB Panel 1 the response: Send them back something and see if 2 they -- 3 MR. ADAMSON: Yes. 4 Were there items in the survey and in 5 your analysis of the survey data where judgment had to 6 be used on what was a correct response? 7 MR. CRONIN: In some cases 8 judgment -- if you have an accounting relationship in 9 which you have two out of three variables, you know, 10 you sort of have the third one defined, yes -- I mean, 11 we used a judgment to determine the materials' share, 12 for example, based on some benchmark data that we got 13 from about 10 or 12 of the utilities. 14 But as it turns out, it really didn't 15 matter. It would not have mattered had we used an O&M 16 definition versus labour and materials. 17 MR. ADAMSON: Did you personally 18 perform the TFP analysis or was it done by someone else 19 in your firm? 20 MR. CRONIN: I actually worked with a 21 colleague to do it. 22 MR. ADAMSON: But under your direct 23 supervision? 24 MR. CRONIN: Yes. 25 MR. ADAMSON: Do you have anyone else 26 do the analysis sort of separately as a triangulation 27 to see if they came to the same answer? 28 MR. CRONIN: No. 293 OEB Panel 1 MR. ADAMSON: Finishing off, I would 2 like to think a little bit about the incentives for 3 cost savings and for the LDCs to actually make cost 4 savings under the three-year price cap plan. 5 How was the period for the 6 first-generation PBR chosen? Where did those sort of 7 time lines come from? 8 MR. KING: Well, they came from a 9 variety of considerations that we made. One was -- we 10 had fairly extensive discussions with the task forces 11 about what an appropriate term for the plan might be. 12 Those opinions seemed to vary quite a bit, with some of 13 the smaller utilities suggesting that they wanted 14 longer terms, largely because they didn't want all the 15 hassle and cost of going through this process repeated 16 time to time. That came about, primarily, through the 17 input that they gave us in the educational and regional 18 workshops last fall. 19 But in the task forces, we spent a 20 fair amount of time discussing what was an appropriate 21 term. The consensus was that something around three 22 years was probably about right. 23 I don't want to make it seem, though, 24 as if we just simply took the task force 25 recommendations and basically endorsed them, because in 26 reality we felt that -- when we looked at the plan 27 itself, there were a variety of, shall we say, robust 28 features of this plan and that there are relatively 294 OEB Panel 1 weak performance standards. 2 The cost basis for initial rates is 3 relatively weak. We don't have -- we are not starting 4 from well-defined cost of service rates. There hasn't 5 been any recent study of what the actual cost 6 attributes are in the province. We have a very -- what 7 would we say -- beneficial transition cost mechanism 8 and Z-factor approach, and when you add all these sorts 9 of things up, it looks like a very nice place to start, 10 a comfortable place to start, for most of the 11 utilities. 12 Not only that, I think that from the 13 PBR team's view, we would like to believe that there is 14 a -- strike that. Let's back up for half a second. 15 There's one other important piece 16 here, which is that the utilities are starting from 17 different cost points, and probably different levels of 18 efficiency. 19 But we don't have at the current 20 point in time any way to be able to assess for a 21 specific utility what is the right level of cost that 22 should be in the utility versus not in the utility and, 23 as a consequence, we believe that the first term should 24 be relatively short. 25 As a consequence, we believe that if 26 we were to put it in, say, to start somewhere in 2002 27 and into 2001, that was too short. We would just be 28 doing PBR non-stop from the time that we started last 295 OEB Panel 1 fall until the time that the next plan gets in place, 2 but to go further than 2000, into 2002, was probably 3 too long and therefore a three-year plan truly winds 4 up, for most utilities, being two and a half years, or 5 something like that, is about right. 6 MR. ADAMSON: So is the three years 7 your recommendation? 8 MR. KING: Yes, it was our 9 recommendation. 10 MR. CRONIN: Could I just add to 11 that? 12 MR. ADAMSON: By all means. 13 MR. CRONIN: We thought that there 14 were -- given the points that might be enumerated, in 15 terms of what we are assuming going in to the plan, we 16 thought that extending it to, say, four years would 17 create problems for potentially the Board and some 18 stakeholders, in that we would be postponing imposition 19 of real performance standards for quite some time. 20 We thought that it would probably 21 take us the three years in order to actually collect 22 the information that's been enumerated: the load 23 research; the cost of service; the reliability; and 24 also putting together the data for the, potentially, 25 yardstick assessment. 26 So we thought that, given that that's 27 one of the objectives of the first generation, it 28 probably could not be done sufficiently well in a 296 OEB Panel 1 two-year period. So that sort of backed us into three 2 as the optimal choice. 3 MR. KING: To be perfectly frank, I 4 mean we had a lot of debate, internal to the team, 5 about whether we should go to four years, two years, 6 three years, and after working through all these 7 issues, we came to three. 8 MR. ADAMSON: Have you performed any 9 financial analysis on the incentives for LDCs to make 10 cost savings over that period? You mentioned it might 11 be short. Really, it's two and a half years by the 12 time they have actually filed. 13 We usually know that (a) cost savings 14 cost money, in the first place; are rarely free up 15 front and may take some time to show effect -- 16 particularly show effects in accounts which, obviously, 17 grows in another line. 18 Have you done any kind of analysis 19 that shows, in your mind, whether LDCs really have a 20 great deal of incentive to make them in that time 21 period? 22 MR. CRONIN: Your point, I think, 23 conceptually, is true. I mean that's one of the issues 24 that we thought about in the fall as we were broaching 25 these issues and, clearly, you create higher incentives 26 the longer the period around which the utility has to 27 recoup the return under the current conditions. 28 We have done a little bit of 297 OEB Panel 1 financial analysis. We think that there is sufficient 2 time for them to recoup these investments, as well as 3 the issue that utilities will probably be facing some 4 kind of more robust competitive, e.g. yardstick, 5 competition in second generation. 6 As you suggest, it does take time for 7 cost savings often to be effected. So if someone were 8 thinking about the longer term -- which is what you 9 need to do for investments -- we think the combination 10 of first generation plus second generation would create 11 higher incentives for people to make those cost 12 savings. 13 MR. KING: Just to follow up on that, 14 that's why, from staff and the team's perspective, in 15 the rate handbook there are these forward-looking 16 statements towards yardstick regulation, the potential 17 advent of yardstick regulation for second generation. 18 As we discussed, there are probably 19 some utilities in the province that don't have their 20 house quite in as tight order as they probably should, 21 and if they are looking towards what's likely to 22 happen, at the end of 2002 going into the next 23 generation, they need to be thinking pretty strongly 24 about starting to make the changes that are necessary 25 so that they won't be adversely affected -- as 26 adversely affected when they get to the next generation 27 of PBR. 28 So it's not just simply the issues of 298 OEB Panel 1 the incentives of this plan, they also had to have a 2 longer-term view towards what's likely to happen after 3 this PBR plan. 4 MR. ADAMSON: Sure. And I think that 5 takes us on to the kind of rebasing issue: 6 Effectively, how are we going to transition from 7 Phase 1 Phase 2? 8 It is known that, potentially, the 9 second generation PBR -- that there is going to be a 10 rebasing of rates. I think, based on your previous 11 comment, you would agree that that could have quite an 12 inhibitory effect -- inhibitory incentive on people to 13 make cost savings in the first generation PBR unless 14 they feel confident that, effectively, some of that 15 payback period may actually extend into the second 16 generation PBR mechanism. 17 MR. CRONIN: Yes, I guess I would 18 agree except that, again, you are facing probably a 19 stiffer regulatory hurdle in second generation. So, if 20 in fact you don't have your house in order now, I guess 21 what we are saying is you are going to have about two 22 and a half years to get your house in better order 23 before that new regime starts. So, I think that it's a 24 carrot and a stick. 25 MR. ADAMSON: Only if that regime 26 looks at the differences in efficiency at the start of 27 that regime rather than changes in -- 28 MR. CRONIN: No. 299 OEB Panel 1 MR. ADAMSON: Actually in LDC 2 efficiency over the period. 3 MR. KING: That's right. That's 4 correct. 5 MR. ADAMSON: Okay. Three final 6 questions, I think, and then -- 7 MR. KING: I would think that in part 8 one needs to be thinking about some sort of rebasing 9 scheme to think about what the absolute level should be 10 going into the next scheme. 11 MR. ADAMSON: Other than the kind of 12 comments that are encapsulated in the handbook and 13 those which we heard of today and yesterday, have you 14 had any other thoughts about how that might be done? 15 It's really just if you kind of identified it as an 16 issue. 17 MR. KING: Well, I think the team has 18 had some comments and some conversation about how 19 rebasing might be done. We think that some sort of 20 empirical analysis, comparative efficiency analysis, is 21 necessary as part of that rebasing scheme. 22 I'm not a big fan of doing 200 or 23 even a hundred cost of service studies because without 24 some sort of management audit, one has no way of being 25 able to determine whether the level of cost is really 26 reasonable in the enterprises. Some sort of 27 comparative benchmarking, perhaps using DEA or other 28 econometric techniques, we would suggest should be part 300 OEB Panel 1 of the mid-term review and part of the rebasing study. 2 MR. ADAMSON: But at least formally 3 there's really no part of the mechanism, as I 4 understand it -- there is nothing that offers any 5 assurances or comfort to LDCs considering cost savings 6 now about how that might occur and what level of those 7 cost savings they might be able to retain. 8 MR. KING: I think that's a fair 9 comment. Part of the reason is that we are consultants 10 to the staff. Staff doesn't make decisions for the 11 Board, and these issues are likely to be issues that 12 have to have the Board actually deal with how they are 13 going to structure the rebasing and the review process. 14 I don't believe that the Board has 15 yet had the opportunity to think that far down the path 16 to be able to develop a view on this. 17 MR. ADAMSON: I would like to cover 18 literally three or four more questions, some of which 19 actually are for the benefit of Mr. Power. He can't be 20 with us this morning. I won't try to capture his style 21 but just sort of ask them on his behalf. 22 Have you worked through any of the 23 implications of the rate unbundling plan described in 24 the handbook, I think especially in Appendix A, for any 25 particular utility? Have you taken that all the way 26 through for any of the companies? 27 MS KWIK: The example, the 28 illustration that I have used, I have depended on the 301 OEB Panel 1 one utility's data as an illustration and worked 2 through it. 3 MR. ADAMSON: Other than that 4 illustration, have you taken it through to see kind of 5 what the impact on final rates might be from the whole 6 set of factors which we know is quite large about tax 7 rates, market returns, so on and so forth? 8 MS KWIK: No, we haven't. 9 MR. KING: Just to clarify. We did 10 do certain other pieces of analysis. I mean, we were 11 looking at the unbundling the 200 and some odd 12 utilities on the basis of their balance sheet then 13 looking at what a market based rate of return might 14 imply. 15 We did not do the further analysis to 16 then, you know, take a handful of these utilities or 17 even one and go through all the elements and make a 18 projection of what it would do to the rate structure 19 and rate levels. 20 MR. ADAMSON: Yes. That was my 21 question about all the way down, I guess, to the final 22 allocation across the various -- 23 MR. KING: No. 24 MR. ADAMSON: Have you done any 25 analysis that suggests how the relative rates between 26 various classes of customers might shift through the 27 unbundling process? 28 MS KWIK: Between the classes? 302 OEB Panel 1 MR. ADAMSON: Yes. 2 MS KWIK: The way the method -- 3 MS LEA: Speak up, Ms Kwik. 4 MS KWIK: The way the method has been 5 developed is to ensure revenue neutrality at a class 6 level. 7 MR. ADAMSON: Yes. 8 MS KWIK: So that there isn't 9 shifting between the classes. 10 MR. ADAMSON: On a revenue basis. 11 MS KWIK: But in terms of within the 12 then class, there is a remark in the rate handbook that 13 asks utilities to consider that impact when they are 14 developing their rates. 15 MR. ADAMSON: Right. But you haven't 16 tried to estimate what might be though. That's for 17 them to consider. 18 MS KWIK: Yes. 19 MR. ADAMSON: In section 4.5.1 of the 20 handbook it describes a 5 per cent flexibility 21 adjustment zone, I think is the phrase. 22 MS KWIK: Yes. 23 MR. ADAMSON: How was the 5 per cent 24 number determined? 25 MS KWIK: There is currently in the 26 rates that utilities are currently using in that 27 design -- the guidelines allows them some flexibility 28 between classes and we tried to assimilate that same 303 OEB Panel 1 flexibility. 2 MR. ADAMSON: Right. So it's based 3 on an estimate of kind of consistency with current 4 practice. 5 MS KWIK: Yes. 6 MR. ADAMSON: One final question for 7 Ms Kwik on behalf of Rob Power. 8 Yesterday we heard that the Board 9 staff took another direction on contributed capital 10 than recommended by your cohorts from Hagler and 11 Bailly. Did Board staff take a different approach than 12 recommended by their consultants in any other instances 13 to your memory? 14 MS KWIK: No. 15 MR. ADAMSON: I'm done. Thank you 16 very much. 17 MS LEA: Thank you, Mr. Adamson. 18 Mr. McKerlie. 19 MR. McKERLIE: Thank you very much. 20 Just one moment. 21 I was hoping to start off with a 22 couple of questions to help me better understand the 23 process that would be followed in terms of an MEU 24 getting started using the handbook and what some of the 25 timing factors would be. 26 There were some questions yesterday 27 with respect to the fact that the handbook timeframe, 28 the handbook approval timeframe, is slipping, I believe 304 OEB Panel 1 is the comment, which was essentially referenced 2 yesterday which was suggesting approval maybe not 3 November, but closer to the end of the year. 4 MS KWIK: Yes. 5 MR. McKERLIE: Recognizing that there 6 is some foundation of dates within this document 7 referencing November, I was just wondering if you could 8 give me your perspective on what the timing would be in 9 terms of initiating the initial rates, how soon could 10 this process be managed, how quickly could I get rates 11 approved and implemented. 12 MS KWIK: Again, it depends on when 13 the final version of the rate handbook comes out. 14 That's when you will have the guidelines available to 15 you to start filing your evidence. You could start 16 filing your evidence as soon as that rate handbook is 17 out, even earlier if you don't mind going through the 18 process of perhaps refiling if there are some parts of 19 the proposal that have changed. 20 Once you have filed then they are 21 proposing a 45-day notice period. The interim rates 22 would not be filed until 45 days after you had filed. 23 MR. McKERLIE: And interim rates 24 would allow me to do what? 25 MS KWIK: It would allow you to start 26 introducing your new rates. 27 MR. McKERLIE: So I could -- 28 MS LEA: I should just put a caveat 305 OEB Panel 1 on that. As you may be aware, sir, interim rates are 2 subject to change retroactively. I just wanted to make 3 that clear. Thanks. 4 MR. McKERLIE: Okay. Thank you. 5 So applying prior to the finalization 6 of the handbook, would that be a practical approach? 7 Would Board staff or anyone be in a position to really 8 address an application? 9 MS KWIK: I guess more than Board 10 staff, it would give you a head start if you started 11 preparing your evidence and just had to make changes to 12 whatever changes the proposal did come out with in the 13 end. 14 MR. McKERLIE: Okay. But really, one 15 would not expect a response prior to 45 days following 16 the finalization of the handbook. 17 MS KWIK: Within that 45-day notice 18 period there is an opportunity for a customer to file 19 comments on your proposal. If the Board feels that 20 based on some of these comments it might be necessary 21 to reconsider some things or possibly even have a 22 hearing on it, then you would have a delay in the issue 23 of the interim order. 24 --- Pause 25 MS KWIK: If for any reason you need 26 to file for a rate change on your existing rate prior 27 to coming into the unbundled rates, I believe you did 28 receive a letter from our licensing division that 306 OEB Panel 1 stated that those applications would be processed. 2 MR. McKERLIE: Okay. And the final 3 rate order would be 90 days approximately? 4 MS KWIK: For the unbundling, yes, 5 that's right. 6 MS LEA: Well, that would depend 7 largely on whether we had intervention. 8 MR. McKERLIE: Yes. 9 MS LEA: During that notice period 10 there is a public notice that you have applied and the 11 opportunity for people to file interventions if they 12 want to. If there is a lot of interest in it, that 13 tends to delay the process because we have to hear 14 those people in some form of hearing. 15 MR. McKERLIE: Okay. 16 I was wondering if I could ask if you 17 could sort of run through the same process for me then 18 that is envisioned in the handbook relative to the 19 subsequent years. So for 2001 and 2002, I believe they 20 are envisioned, it does reflect some dates, if I could 21 understand that. 22 MS KWIK: If that aspect of the 23 proposal is accepted, those dates will stay in place, 24 the ones for the subsequent -- for the rate 25 adjustments. If the Board decides that is the way to 26 go then the timing of the filings for the second and 27 third year would stay in place as proposed. 28 MR. McKERLIE: So maybe then a couple 307 OEB Panel 1 of specific questions. 2 So the LDCs are requested to file 3 data prior to February 1st? 4 MS KWIK: That's right. 5 MR. McKERLIE: The data is then 6 managed or calculates an IPI, perhaps some other 7 indicators, but I don't -- I believe IPI. 8 MS KWIK: That's right. 9 MR. McKERLIE: I stand corrected, but 10 by February the 15th? 11 MS KWIK: Yes. I believe that was 12 the date, yes. 13 MR. McKERLIE: Does that time -- 14 MS KWIK: Then the adjusted rates 15 would come in effect on March 1st is what is proposed. 16 MR. McKERLIE: So is that the intent 17 that rate change dates would be for March 1st? 18 MS KWIK: The 1st, that's right. 19 MR. McKERLIE: Okay. Does the time 20 frame from February 1st to February 15th to calculate 21 and provide the IPI response and then the subsequent 22 time to implement rates for March 1st, does that time 23 frame cause you any concern for an MEU practically 24 managing that implementation of rate? 25 MS KWIK: I guess our view was it 26 wasn't and that is why we proposed it. I think if you 27 feel otherwise perhaps let us know that. 28 MR. McKERLIE: Presumably, if the 308 OEB Panel 1 effective date was March 1st and the implementation 2 could not be managed by the LDC for March 1st, the 3 thinking was that they would be implemented 4 retroactively to March 1st? If an LDC was not capable 5 of managing that for March 1st, but say it was April 6 1st, they would put through a retroactive adjustment to 7 March 1st. 8 Is the thinking that all LDCs are on 9 a March 1st time frame now? 10 MS KWIK: Yes. As far as retroactive 11 rates I do not believe that the Board -- does the Board 12 issue retroactive rates? That would be up to the Board 13 whether they would allow retroactivity on those rates. 14 MS LEA: Again, it has to do with the 15 date that interim rate starts. We do not change rates 16 retroactively. This has not been made interim 17 previously. So it is a kind of a squarely legal issue 18 and it works out on a practical basis when the 19 application comes. 20 MR. McKERLIE: I guess that is really 21 part of my question, though. This process has been 22 designed to be, as I read it, fairly straightforward: 23 you receive information on the IPI; you develop the 24 impact of your rates from that factor, recognizing of 25 course you don't wait and start on February 15th, I 26 understand that, but you develop the rates to be 27 effective March 1st, if there is some reason that it is 28 difficult to have them ready to go for March 1st rates. 309 OEB Panel 1 Does that then require subsequent 2 approval from the Board even if you are not ready to 3 implement them in time? 4 MS KWIK: No. 5 MR. KING: Well, with one proviso. 6 If there is a rate decrease, then I think there would 7 have to be some sort of a mechanism to deal with the 8 fact it wasn't implemented when it was supposed to be. 9 If there is a rate increase it would seem to me that 10 you would likely execute or lose it. 11 MR. McKERLIE: So if you are not 12 ready for March 1st, if you are not ready until April 13 1st, you are suggesting you would lose that rate 14 increase for the month? 15 MR. KING: Yes. 16 MS LEA: I am not sure that is how it 17 would work, actually. 18 MR. KING: Why don't we do this? 19 Brian, why don't you put that in your submission as one 20 of the points you would like clarification on with an 21 argument of which way you think it should be, and the 22 Board will be able to, in issuing the final rate 23 handbook, make a determination of which way it will go. 24 MR. McKERLIE: Okay. 25 MS LEA: Another suggestion, sir, is 26 the actual people who will be implementing this and 27 then setting these dates and so on are perhaps not the 28 three that are before you today. They probably work in 310 OEB Panel 1 the facilities and applications, licensing and 2 applications branch. 3 So there are more sources of 4 information than you have from these three folk today, 5 and we can help you with that. 6 MR. McKERLIE: Okay. You just took 7 my next question, but now that I have the answer, that 8 is fine. 9 If the LDC implements the rates in 10 2000 effective with market opening, I guess currently 11 viewed to be November 1 of 2000, are there any issues 12 associated with the fact that you would then be 13 implementing Year 2 rates some four months after that, 14 March 1st of 2001? 15 MR. KING: What issues might there 16 be? 17 MR. McKERLIE: I was hoping you would 18 help me figure that out. I mean, you are applying, I 19 guess, for a Year 1 rate increase to reflect the new 20 structure and then some four months later you are 21 adjusting your price for an IPI and a productivity 22 factor. 23 MR. KING: Right. 24 MS KWIK: We didn't foresee any 25 problems with that. 26 MR. McKERLIE: Okay. 27 Can I just ask a couple of questions 28 about the economic model as it applies to system 311 OEB Panel 1 expansion? I think there were a couple of questions 2 yesterday and I was hoping to follow up on that 3 briefly. 4 I understand that the economic model 5 for a system expansion is a separate process -- 6 MS KWIK: That's right. 7 MR. McKERLIE: -- in developing that 8 model, but I believe there was a statement yesterday 9 which indicated that the O&M for the new systems would 10 still be collected. Could you tell me what you mean by 11 that? 12 MR. CRONIN: Was that part of the 13 contributing capital discussion? 14 MR. McKERLIE: Yes, it was. 15 MR. CRONIN: I think what we are 16 saying is that for historic capital you would continue 17 to receive a cost of maintaining that contributing 18 capital even going forward. I don't think we were 19 relating that to the discussion of system expansion, if 20 I recall correctly. 21 MR. McKERLIE: So to the extension 22 that system expansion is additional rate base that is 23 not part of the calculated market-based rate of return 24 revenue requirement, in other words, it happens in a 25 year different than rebasing, I assume then that rate 26 base has not been included in the rate of return 27 calculation? 28 MR. KING: Just a moment. 312 OEB Panel 1 --- Pause 2 MR. KING: Well, current rates. The 3 process begins with current rates and it makes an 4 adjustment for current rates to deal with the inclusion 5 of additional capital that is being deployed in that 6 year, right? So if that is the case, then currently it 7 should be sufficient to be able to -- as long as those 8 current rates are sufficient to be able to recover the 9 routine capital expansions that are occurring in the 10 system, there shouldn't be an issue. 11 It is only if going forward you are 12 expecting that your capital additions are going to be 13 wildly different than your historic capital additions, 14 then there is more of an issue. That shouldn't be the 15 case. 16 MR. McKERLIE: I am sorry. So the 17 current rate is based on an expectation of capital 18 expansion. So if I move into -- 19 MR. KING: No, I am sorry. It is 20 based upon actual capital addition to that year. 21 MR. McKERLIE: So if I am applying 22 for new rates in the year 2000 and it is based on, I 23 assume, my 1999 rate base plus an estimate of 2000 24 capital expansion? 25 MR. KING: No. It's based upon 1999 26 capital base which included your capital additions in 27 1999. 28 MR. McKERLIE: Okay. So in 2001 I 313 OEB Panel 1 invest another $3 million. How am I getting return on 2 that? 3 --- Pause 4 MR. CRONIN: Your rates go up by the 5 input price index and you make an investment based on 6 business expectations. 7 MR. McKERLIE: So based on the 8 economic model? 9 MR. CRONIN: M'hm. 10 MS LEA: You have to answer yes or 11 no, please, sir. 12 MR. CRONIN: Say "yes". 13 MS LEA: I heard an "M'hm". An 14 "M'hm" is equivocal. I don't mean you can only answer 15 yes or no. 16 MR. McKERLIE: So to the extent that 17 the economic model shows a customer or load growth that 18 provides for a less than market-based rate of return on 19 the capital in the first year below a market-based rate 20 of return on the entire project, then as an LDC I would 21 be coming up short in the years of investment? 22 MR. CRONIN: I think one of the 23 reasons why we wanted a fixed charge was that that 24 would create an equilibration between changes in 25 connections and revenues. As it was recommended by the 26 Rate Design Task Force, the fixed charge element is 27 much smaller and the utilities agreed that they were 28 assuming some of the risk in that rate design. 314 OEB Panel 1 MR. KING: So in fact what you now 2 have is that if you have an expansion of the system 3 because you are adding customers, then you have 4 additional revenue that comes through, in part through 5 the IDC and in part through the fixed charge on the 6 expanded number of customers. So the intent is, you 7 know, if your capital expenditures are radically 8 different then it is a problem, or it might be a 9 problem, but if your capital expenditures are along the 10 way that they have been over the past 10 years then 11 those sorts of mechanisms probably are fine. 12 MR. McKERLIE: So new expansion is 13 paid for by the new customers on that system? 14 MR. CRONIN: Well, you can still 15 accept contributions in aid of construction; you just 16 can't get a rate of return on it. 17 MR. McKERLIE: Unfortunately, it is 18 one of the concerns is we are kind of hopping back and 19 forth with the economic model which is outside this 20 discussion. 21 But if I presume that the economic 22 model for capital additions reflects the profitability 23 of the entire project -- if I could assume that for a 24 second. Typically, though, a utility investment would 25 reflect a lower return in the first years to the extent 26 that new customers coming on do not cover the capital 27 investment which is typically a large portion of the 28 investment. 315 OEB Panel 1 Maybe a specific example: Installing 2 a new subdivision, the developer decides he wants to 3 build the house at the end of the street. I have to 4 install the wire all the way down the street, but I'm 5 only getting the revenue from the one customer at the 6 end of the street. 7 So I guess I'm concerned about the 8 disconnect relative to the growth of those capital 9 projects. 10 MR. KING: But isn't it also true 11 that there is a net present value analysis that is 12 looking at the cash flows of the addition to those 13 customers? 14 MR. McKERLIE: Sure, but in the first 15 years I'm still coming up short. 16 MR. CRONIN: But that's not unusual 17 for investments. 18 MR. McKERLIE: I understand that. 19 MR. CRONIN: That is basically what 20 firms in most markets have to consider. I mean, 21 nobody -- firms in other markets typically don't have 22 some kind of guaranteed rate of return; they make 23 investment decisions based on net present value, the 24 discount rates applied to that risk preferences, and 25 what we are suggesting is that for the vast majority of 26 utilities that would be how the model worked. 27 We were in favour of actually trying 28 to strengthen the relationship between changes in the 316 OEB Panel 1 size of the system and the revenue that would flow to 2 the utilities. 3 MR. McKERLIE: Okay. 4 Is it not typically the case in a 5 cost of service mechanism that to the extent that the 6 investment portfolio of a utility comes up less than 7 their approved rate of return there would be an overall 8 adjustment in rates to allow for that? 9 MR. KING: Only at the time of a rate 10 case. 11 MR. McKERLIE: Right. 12 MR. KING: In between you take 13 whatever the result is. So often, you know, you would 14 have capital additions in a specific year and it may 15 not be covering the cash flow or the return on that 16 equity until the next rate case. 17 MR. CRONIN: That is actually one of 18 the features that we were trying to get away from, 19 which is that the utility, the management and 20 shareholders have to assume more risk in how they run 21 their business. Associated with that are rates of 22 return that go, at least initially, from 10 to 15 per 23 cent. 24 MR. KING: So we want you to think 25 about deploying the capital and ensuring that the 26 capital is going to be productive over the course of 27 its life. 28 MR. McKERLIE: I can appreciate that 317 OEB Panel 1 philosophy. 2 I guess in the situation where you 3 have developing municipalities where the capital 4 expenditure is a significant component of the existing 5 rate base, would you agree that -- and again, this 6 depends on the outcome of the economic model. 7 But it would seem to me there will 8 still be a component, as you have already referenced, 9 of contributed capital contributions in aid to 10 construction, and as a result you are going to end up 11 with an issue of trying to justify that to the 12 developer in the community. One of the differences, I 13 guess, of this business is that there is not a lot of 14 option as to whether or not you provide this service. 15 MR. KING: Well, I'm not sure exactly 16 what the proposal is for the economic model under the 17 system expansion so I can't specifically comment on 18 what it is. 19 But it would seem to me that a 20 reasonable concept is something along the following: I 21 have a capital project, an expansion of the system for 22 development. I do a projection of what the timing of 23 cash flows under expected rates are. I look at the 24 shortfall that that revenue has to cover the servicing 25 of that capital and the residual is the -- on a net 26 present value basis is perhaps what I would charge as a 27 charge in aid in lieu of construction. 28 Is that more or less the proposal 318 OEB Panel 1 that is there? 2 MR. McKERLIE: Unfortunately, I 3 haven't seen it either. That is, I guess, part of my 4 concern. 5 MR. KING: Okay. Well, I think 6 your -- 7 MR. McKERLIE: But I guess the point 8 is -- 9 MR. KING: -- concern is well placed 10 that these things somehow have to match up. You know, 11 you can't have a disconnect between -- 12 MR. McKERLIE: Okay. 13 MR. KING: -- the two. It seems to 14 me they should match up. 15 MR. McKERLIE: I guess that's what 16 I'm trying to get at. To the extent that the initial 17 years do have a shortfall in revenue and that is a 18 significant component of -- that growth dollar figure 19 is a significant component of the existing rate base on 20 which a utility is earning on, I think we will see that 21 sort of the annual earnings take a real impact in some 22 municipalities. 23 But again, until we see it I'm not 24 sure how we can go much further. 25 MR. KING: Well, initial earnings may 26 not be as high as one otherwise would have, but 27 supposedly there is a cash flow stream subsequent where 28 earnings would be higher, otherwise you wouldn't 319 OEB Panel 1 undertake the investment. 2 MR. McKERLIE: I agree with that. 3 MR. KING: Okay. 4 MR. McKERLIE: My suggestion is the 5 up-front impact. 6 MR. KING: And while there are issues 7 associated with how folks look at earnings, certainly 8 in the public markets what is rewarded is growth in 9 earnings as opposed to aggregate level of earnings. So 10 some would suggest that growth in earnings and showing 11 a growing earnings stream over time is likely to result 12 in a higher valuation of the firm and hence a higher PE 13 multiple. 14 MR. McKERLIE: I guess my one final 15 and then maybe I will move on. 16 My concern is, I can see the 17 situation where you invest based on an NPV of a total 18 project and you end up with a cash flow that at a 50:50 19 debt-equity structure may not even be servicing the 20 debt, because my cash flow, as you have pointed out, is 21 only going to be driven by the incremental revenue 22 attached to that system set at rates which were going 23 to be determined based on a rate base prior to me 24 making that investment. 25 MR. KING: I agree, Brian. That's a 26 big problem. 27 If that is what happens, then that is 28 a problem. It will not be financed because you won't 320 OEB Panel 1 find a bank who will lend on the basis of a coverage 2 ratio that is south of what. They generally don't like 3 that. 4 MR. McKERLIE: Okay. 5 Maybe a way to wrap this up would be 6 to get a sense for when we might have information on 7 those guidelines. 8 MS LEA: Unfortunately, Mr. McKerlie, 9 we don't know. I wish I could give you more 10 information. 11 Two things. I think that -- 12 --- Pause 13 MS LEA: Mr. McKerlie, during the 14 break I will try and find who is working on those, get 15 you the name and phone number. 16 Further, we really appreciate your 17 comments and suggestions on this and we will bring them 18 to the attention of the people who are working on the 19 facilities expansion guidelines. 20 MR. McKERLIE: Thank you. 21 MR. CRONIN: Speaking of breaks -- 22 MS LEA: Yes. 23 Sir, that completes your questioning? 24 MR. McKERLIE: No. 25 MS LEA: Do you mind if we take a 26 break now, sir? 27 MR. McKERLIE: Absolutely not. 28 MS LEA: All right. Thank you very 321 OEB Panel 1 much. 2 We will take 15 minutes and a bit. 3 Five to 11:00 please. 4 --- Upon recessing at 1036 5 --- Upon resuming at 1100 6 MS LEA: There are some matters of 7 scheduling that -- as you have no doubt observed, we 8 are having a great deal of difficulty finishing our 9 business today. 10 Could we reconvene please? 11 --- Pause 12 MS LEA: We had several parties 13 scheduled for today and we won't reach you all. 14 Mr. Gibbons and Mr. White, thank you 15 very much for your flexibility. You will not be making 16 your presentations today I doubt. I think we will 17 probably be looking towards Friday afternoon for you, 18 but we can confirm that with you and find out what a 19 good time is. 20 With respect to the Vulnerable Energy 21 Consumers Coalition witness, I would like to thank 22 Mr. Janigan very much for his and his witness' 23 flexibility. The intention at present is to schedule 24 that witness for 9:00 a.m. next Monday morning. That 25 would be John Todd for the VECC at 9:00 a.m. next 26 Monday. So that is what we are looking at. 27 We do have three parties who have 28 indicated that they have to get done today. 322 OEB Panel 1 Nepean Hydro: I think those gentlemen 2 have to leave mid-afternoon. The CAC's witness also is 3 available only today. I understand further now that 4 the Upper Canada Energy Alliance also has people who 5 are only available today. 6 The difficulty we face is also that 7 Mr. King is only available today. So we are going to 8 attempt to fit as many of these things in as we can. 9 One moment. 10 --- Pause 11 MS LEA: If this panel stands down 12 for a few minutes, are the gentlemen from Nepean Hydro 13 ready to go? 14 All right. I think we have three 15 questioners left for this panel. 16 Let's do that, then. I understand 17 the schedule for Nepean Hydro is extremely tight. 18 Gentlemen and Ms Kwik, if you could 19 step down, we will bring the Nepean Hydro panel 20 forward. 21 Thank you. 22 --- Pause 23 MS LEA: I'm sorry, Mr. McKerlie. We 24 will just get to you as soon as we can. 25 You can go up there or you can sit 26 here, wherever you please. 27 --- Pause 28 MS LEA: I think the reporters are 323 OEB Panel 1 requesting that you sit at the desk. That's fine. If 2 that does help, that's good. 3 Gentlemen, can I ask you to introduce 4 yourselves and go ahead and make your presentation and 5 then we will find out what questions there are for you. 6 --- Pause 7 ARTHUR EMMET 8 GERRY DUPONT 9 PRESENTATION 10 MR. EMMET: Thank you, Ms Lea. 11 My name is Arthur Emmet. I am the 12 General Manager of Nepean Hydro. With me is Gerry 13 Dupont, our Comptroller. 14 We are here this morning to speak 15 about the contributed capital issue, but before we 16 begin I would like to make a couple of comments as a 17 member of the Yardstick Task Force. 18 It has been suggested here in the 19 last couple of days, or at least it seems to me it has 20 been suggested, that the OEB staff, under the influence 21 of their consultants, decided to abandon the yardstick 22 approach. 23 I would like to suggest the contrary; 24 that it was their intent, as the consultants indicated, 25 to create a yardstick regime. In fact, the Board staff 26 convened a yardstick task force for exactly that 27 purpose. 28 The objective of that task force was 324 Nepean Hydro Panel 1 to identify, quantify and assess the characteristics 2 determining the number of yardstick groupings and 3 assignment of utilities to a group. That was our 4 purpose. 5 In fact, I believe the members of the 6 task force realize that and recognize it as the goal 7 going forward. 8 It was the task force members who 9 concluded that there was insufficient information and 10 data available to create supportable yardstick 11 groupings. 12 I can only speak for myself, not for 13 the other task force members. Quite frankly, I'm 14 arrogant enough to believe that our utility would do 15 very well under a yardstick regime. I think we have 16 achieved reasonable productivity, and I personally 17 would be very disappointed if we don't adopt it in 18 generation two. 19 But I can tell you that the task 20 force members discussed at length the issues we have 21 heard regurgitated here today. In fact, the only 22 conclusion that we were able to draw was that if you 23 were going to go forward with task force -- sorry -- 24 with a yardstick regime it would have to be done simply 25 on the basis of size of utilities with really no 26 rationale for splitting them up. 27 I know that members in caucus and 28 also in smaller groups tried to find a way to at least 325 Nepean Hydro Panel 1 recognize differences in costs per customer in some 2 sort of a differential PBR scheme; that is, to require 3 higher cost firms to achieve a higher productivity 4 factor for any given return. Again, I believe under 5 such a regime my own utility would benefit. 6 We concluded that the data simply was 7 not available to account for cost drivers that are 8 beyond management's control. So I would just like to 9 say that I believe my own utility would have benefitted 10 from a full yardstick regime if we had been able to 11 adopt one, or a cost differential scheme. 12 But I'm convinced that the task force 13 conclusion was correct and appropriate for a two-year 14 learning period. I would just like to state that for 15 the record. 16 Perhaps I would also add that as a 17 manager I have accepted the fact that our industry is 18 changing and that there will be considerable 19 uncertainty going forward. 20 I think we have to move on. We have 21 to understand the plan and start formulating 22 strategies. 23 If the risk of going forward is 24 minimal -- and we think it probably is -- then let's 25 move and start educating all utilities about the plan 26 in the first phase of PBR. We have 250 utilities that 27 need to get on with this job. 28 We believe that the Board has 326 Nepean Hydro Panel 1 undertaken an extensive consultative process and that 2 further endless debate will only serve to delay and 3 derail the process with no net benefit to anyone; and, 4 in the end, the customer will pay the piper. 5 Having said that, I would like to 6 talk about contributed capital. 7 Nepean Hydro serves 120 -- I'm sorry. 8 I'm getting all mixed up here. 9 Nepean Hydro serves 125,000 residents 10 and a total of 42,000 customers in the City of Nepean. 11 For the record -- and as I have 12 indicated a moment ago -- our commission has, for 35 13 years fairly and effectively represented the interests 14 of our customers it was elected to serve. 15 Consequently, our utility has 16 fulfilled its mandate of providing a high level of 17 reliability and service, at the lowest possible cost. 18 Gerry and I are here today 19 representing both our Commission and the City of 20 Nepean, to share our perspective on the appropriate 21 treatment of contributed capital on the rate base. 22 We will, I hope, be mercifully brief. 23 I will touch on some of the public policy issues and my 24 accountant friend here will comment on financial 25 issues. We will leave it to the economists to debate 26 the efficient use of capital. 27 For an independent perspective on 28 this subject, we would draw your attention to the 327 Nepean Hydro Panel 1 written submission received by the Board from Acres 2 International. 3 The central issue before us is how to 4 make the transition of the treatment of contributed 5 capital from a past power cost philosophy to a 6 commercialization philosophy in a manner that is 7 ultimately fair to the customers of the MEU and 8 equitable to all customers across the province. 9 We do agree with Mr. King's statement 10 yesterday that contributed capital is primarily a 11 policy issue. 12 Let me say, from the outset, that we 13 believe that historic contributed capital should be 14 included in the rate base and it should attract the 15 OEB-approved market-based rate of return. 16 Proponents who advocate removing 17 historic contributed capital from the rate base appear 18 to make three arguments: first, investors ought not 19 make a return on someone else's investments; second, 20 customers who have paid contributed capital ought not 21 to be required to pay twice; and, finally, that 22 removing contributed capital from the rate base will 23 serve to keep rates lower than they otherwise would be. 24 These arguments ignore the reality of 25 what is happening in the electricity industry in 26 Ontario today. 27 There's no question that in a 28 regulated for-profit environment, where investors earn 328 Nepean Hydro Panel 1 a return on their investments, they should not be 2 permitted to make a return on other people's 3 contributions. However, electricity distribution in 4 Ontario has been anything but a for-profit industry. 5 It has been, in effect, a not-for-profit public sector 6 co-operative. 7 In fact, the existing legislation 8 prevented us from being anything else. 9 Utilities have been directed, on 10 behalf of ratepayers -- who are the notional owners -- 11 by commissioners who have been elected by those 12 ratepayers to represent their interests. It is the 13 ratepayers who have paid 100 per cent of the capital 14 assets of MEUs and they have received a return not in 15 the form of a dividend but through lower rates. 16 Commissions elected by and 17 representing the interests of the ratepayers have 18 determined the fairest way of paying for capital 19 assets: using a combination of rates and contributed 20 capital. These being the only available sources of 21 funding. 22 These were valid policy decisions, 23 based on the rules of the day. In fact, the whole 24 purpose of contributed capital is different in an 25 investor-owned utility than it has been in the Ontario 26 distribution industry. 27 In the gas industry, for example, I 28 believe contributed capital is only collected when 329 Nepean Hydro Panel 1 specific investments will not provide a market base 2 rate of return. Under our co-operative model, return 3 on investment has not been an issue. Contributed 4 capital has been used extensively to cover 5 growth-related costs. 6 Under these circumstances, the 7 distinction between sources of capital is totally 8 artificial. The question of whether an investment were 9 in a return was never asked. The co-op has an 10 obligation to connect all customers in accordance with 11 the cost-sharing policies of its board of directors. 12 Now, the provincial government has 13 made a decision to restructure the electricity 14 industry. With respect to municipal utilities, the 15 government had to address a difficult question: How do 16 you put a co-op on a commercial footing and who will be 17 the owner? 18 The answer to the second part of the 19 question was: the municipality. 20 At least one intervenor -- I believe 21 it was the Consumers Association of Canada -- has noted 22 in its submission, as we have in ours, that, 23 essentially, ratepayers and community owners are 24 congruent, Consequently, we believe that the new 25 shareholder is ideally position to balance the 26 interests of ratepayers and taxpayers -- who are, 27 essentially, one and the same. 28 Energy Probe in their submission 330 Nepean Hydro Panel 1 notes, as we have, that no one other than the ratepayer 2 has invested in the capital assets of the utility. 3 Their conclusion is that no one should earn a return on 4 any of the existing assets of municipal utilities -- a 5 line of reasoning which is consistent with our previous 6 not-for-profit model and one to which I, myself, am 7 partial, having spent some 31 years in our industry. 8 However, the government's goal is 9 clearly stated in the White Paper and confirmed in the 10 legislation; and from the White Paper, quoting: 11 "The local utilities would also 12 be put on a commercial footing, 13 consistent with the OBCA, 14 providing them with the 15 flexibility they need to make 16 the important business decisions 17 that lie ahead." (As read) 18 And further: 19 "Similarly, in reviewing local 20 distribution tariffs, the OEB 21 would be expected to make an 22 appropriate allowance for a 23 normal rate of return." 24 (As read) 25 The government's goal is clear -- and 26 we believe it would be inappropriate for the Board to 27 make any decision which would have the effect of 28 frustrating the achievement of that goal. 331 Nepean Hydro Panel 1 Board staff are incorrect when they 2 state that no one will be worse off with the proposed 3 treatment of historic contributed capital. 4 Municipalities whose utilities have utilized 5 contributed capital will definitely be worse off. 6 The government has placed an economic 7 tool in the hands of municipalities. But some 8 municipalities would receive only half a tool or a 9 quarter of a tool, depending how much contributed 10 capital is on their books. 11 If one wishes to argue that 12 municipalities should not be able to earn a return on 13 assets because they have not invested in them, that is 14 a matter that ought to be taken up with the provincial 15 government that made the decision in the first place, 16 not with the OEB. 17 But to argue that as part of putting 18 utilities on a commercial footing a utility's assets 19 should be arbitrarily split into two categories, assets 20 with value and assets without value, is totally 21 inappropriate and is inconsistent with government 22 policy. 23 And when I say totally without value, 24 Gerry will get into that. 25 But, essentially, if you have had a 26 zero rate of return on your capital over the past five 27 years, then, allowing your historic rate of return, 28 multiplying by zero is something even I can do. 332 Nepean Hydro Panel 1 Remember, it is only the ratepayers 2 who have paid for those assets, in accordance with the 3 policies of their elected board of directors. 4 Furthermore, municipalities clearly 5 would not be going forward on an equal commercial 6 footing, and many would not have the degree of 7 flexibility contemplated by the government. Some would 8 have their options severely restricted as a result of 9 past public policy decisions; again, a situation that 10 surely was not intended by the provincial government 11 and is not in the best interests of ratepayers or the 12 community. 13 The consequences of paying less than 14 a market-based rate of return on contributed capital is 15 significant, given that for some utilities contributed 16 capital represents up to 80 per cent of the total asset 17 base -- and Gerry will address the financial issues. 18 MR. DUPONT: Thank you. 19 I am going to be brief. I just want 20 to emphasize and add a couple of things to what Arthur 21 has already said. So let me start off by addressing 22 the impact that contributed capital might have on 23 rates. 24 Some clearly say that it is totally 25 unfair to place past contributed capital on the rate 26 base because that would mean that the customer would 27 pay twice. 28 Now, as Arthur already said -- but I 333 Nepean Hydro Panel 1 think it's really important so I want to repeat it -- 2 that argument is only true if a utility could earn a 3 return. But that was not possible in the past under 4 the old Power Corporation Act. Utilities were 5 obligated to operate them at power of cost or 6 not-for-profit basis. That meant that the customer was 7 charged a combination of rates and charges designed to 8 recover the total expenditures the utility had to make 9 to build and maintain an electricity distribution 10 system. 11 In other words, the utilities did not 12 invest in an asset on which it could earn a rate of 13 return. There was no rate of return. Rather, it 14 simply purchased an asset required to render services 15 to its customers, and that asset was paid for by 16 customers, through rates and/or user charges. 17 So, based on this regulatory and 18 not-for-profit environment, some utilities adopted a 19 "pay as you go" policy, where costs were recovered 20 through charges levied against those customers who 21 caused the costs to be incurred, in the first place. 22 Under the old act, there were quite a 23 few examples of that, and some examples of specific 24 charges that were recovered through charges, not 25 through rates, were: collection charges; reconnection 26 charges; change of occupancy charges. Those kinds of 27 charges. 28 If a utility chose not to do this, 334 Nepean Hydro Panel 1 then retail customers would have to have an increase. 2 In other words, if you decided not to 3 choose to recover some costs through this -- because 4 contributed capital, clearly, has been put in the same 5 categories as those kinds of costs that are directly 6 recovered through customers. If a utility chose not to 7 do that, then the costs would have to be recovered from 8 customers, one way or another. And customers who 9 obtain an aesthetic benefit -- say, those customers who 10 decided that they wanted to have their wires buried in 11 their subdivision -- they would get a free ride. 12 So if no contributed capital is 13 obtained from them, they would get a free ride because 14 part of their costs would have been subsidized by 15 existing customers. 16 So utilities had the flexibility 17 under the old regulatory scheme to either levy these 18 charges or not, and both were very valid policy 19 decisions made by the commissioners who were supported 20 by their customers, elected by customers. They made 21 those valid policy decisions. 22 I would submit that it would be 23 totally wrong to now go back and reverse those 24 decisions by some action that would be deemed to be 25 punitive or seemed to be punitive to the utilities who 26 had contributed capital in their books. 27 So, the key point here is that those 28 utilities who collect their contributed capital decided 335 Nepean Hydro Panel 1 that existing customers should not subsidize growth and 2 that the customers causing these kinds of costs should 3 pay for it through a contributed capital charge. 4 Now, I know that the Board is very 5 interested, very concerned about cross-subsidization. 6 I would submit to you that if you go back and say 7 contributor capital is not allowed to be in the base, 8 then that's what in fact you are doing. You are going 9 to impose the subsidization by existing customers, at 10 least in the past. 11 MS LEA: I'm sorry, I didn't 12 understand the last phrase there, sir. You are going 13 to impose -- 14 MR. DUPONT: If the Board was to 15 impose a decision that said contributor capital is not 16 allowed to be in the rate base, then that would mean 17 that you are saying that all those existing customers 18 in the past who did not subsidize because we did charge 19 a contributor capital charge, you are now reversing 20 that decision and essentially it would mean that those 21 existing customers would be subsidized. 22 Now, I would like to address the 23 historical rate of return. The question is how should 24 past contributor capital be handled? First of all, we 25 all agree that future contributor capital be excluded 26 from the rate base because clearly the business 27 environment is changing. It is moving from a not 28 profit to a profit basis. 336 Nepean Hydro Panel 1 Any customer contributing contributed 2 capital in this environment will be paying twice. We 3 agree with that. Therefore, moving forward we have no 4 problem in not attracting a rate return on that 5 contributed capital. But, utilities would know that's 6 the new policy and would make appropriate decisions. 7 For a past contributed capital we 8 strongly recommend that it is allowed to earn a return 9 at the same rate as all other capital because, as I 10 stated earlier, it doesn't matter. It didn't matter in 11 the past how assets were financed. 12 The staff handbook recognizes this 13 because it separates out what past contributed capital 14 can earn. The only problem is the method that was 15 chosen in the staff handbook. What the staff handbook 16 says is that historical rate of return be allowed to 17 earn a return that is reflective of the past return the 18 utility achieved. 19 If you do that -- and I think it was 20 stated yesterday -- you are going to have hundreds of 21 different rates. So where is the equity in this? 22 Also, for us, for Nepean for 23 instance, the past six years we earned a negative half 24 a per cent on our sales. We were not operating in a 25 for-profit basis, so it's not surprising that this 26 should happen. Utilities will have their own very 27 specific past returns on their sales and, therefore, an 28 asset. 337 Nepean Hydro Panel 1 Providing a rate of return on past 2 contributed capital that is based on that, we submit, 3 is totally ineffectual and inappropriate. What we 4 conclude is that past contributed capital should 5 earn -- the rate of return should be the same for 6 everybody. That rate of return should be the market 7 based rate of return that's allowed by the OEB. 8 Thank you. 9 MR. EMMET: Just in conclusion, 10 actually I was looking at -- again, I think it's the 11 CAC submission. While I do not agree with their 12 conclusion, they do have a statement in their 13 submission regarding contributed capital. It says in 14 terms of trying to straighten it out in talking about 15 removal of contributed capital from the rate base 16 historically, they say: 17 "However, enforcing this rule 18 would affect LDCs in very uneven 19 ways. It would constitute a 20 regulatory recontracting and 21 likely raise complex 22 confiscation arguments." 23 (As read) 24 I think if I understood that, I would 25 agree with it. 26 --- Laughter 27 MR. EMMET: I would like to suggest 28 that there is another goal -- sorry, I would like to 338 Nepean Hydro Panel 1 suggest another goal of this government is to encourage 2 local accountability in decision-making. 3 A number of intervenors purport to 4 represent the interests of the ratepayers of municipal 5 utilities. However, the government has, I think 6 correctly, in moving from a co-op model to a 7 commercialized model determined that the entity in the 8 best position to represent both taxpayers and 9 ratepayers is the municipality. 10 The past decisions relating to 11 contributed capital in Nepean were made in a public 12 forum by a commission elected to represent its 13 ratepayers. We are here today representing both that 14 elected commission and the elected council and future 15 shareholder of the corporation. They believe, and I 16 believe, that they are in the best position to act on 17 behalf of those ratepayers. 18 As we have indicated in our written 19 submissions, the only way to comply with the 20 government's direction with respect to establishing new 21 corporations on a commercial footing and to treat both 22 municipalities and the ratepayers in a fair, consistent 23 and equitable manner is to include historic contributed 24 capital in the rate base at a market based rate of 25 return. 26 Thank you. 27 MS LEA: Thank you very much, 28 gentlemen, for an informative and enjoyable 339 Nepean Hydro Panel 1 presentation. 2 Does anyone have questions for the 3 gentlemen from Nepean? I don't see any takers. 4 Ms Kwik, do you have a question? 5 MS KWIK: Yes. Going forward, 6 assuming no return is earned on the contributed capital 7 collected in the future and absent any guidelines on 8 the collection of contributed capital, what kind of 9 changes would you see yourself making to your 10 contributed capital policy? 11 MR. EMMET: That's a darn good 12 question. Set the rules and I think we will start to 13 address it. That's a very important issue. I suspect 14 we will get direction from the Board on this matter, 15 but I would anticipate that our -- hey, I'm going to 16 pull a consultant's trick. 17 We are going to look at the options 18 available and make the decision in the best interest of 19 our customers. 20 MR. DUPONT: In essence, I think that 21 we will have various options going forward. 22 Contributed capital, we think, we have heard from the 23 Board that that will remain an option. Clearly, we 24 will have to contemplate that, but we will know that if 25 we continue with contributed capital, it will earn no 26 rate of return. 27 What I personally envisage here is 28 that going to my Board of Directors, I would be 340 Nepean Hydro Panel 1 proposing various options. I will be doing some 2 analysis, one of which will be the one I have just 3 mentioned. The other one will be should we maybe incur 4 debt to fund this. That's another possible option. I 5 will attach implications to that hat. 6 Going forward, I would like to have 7 those two options and maybe there are more. 8 MS KWIK: Thank you. 9 MS LEA: Mr. Adams. 10 MR. ADAMS: I wonder if I would have 11 an opportunity to ask a few questions. 12 My name is Tom Adams. I represent 13 Energy Probe. I just have a few brief questions to 14 understand your position. 15 If Board staff's position in the 16 draft handbook on contributed capital is adopted, can 17 you help us understand the impact on commercialization 18 of your utility? What will happen? 19 MR. EMMET: In terms of our rate 20 base -- 21 MR. DUPONT: Impact on 22 commercialization. What you mean here is impact on 23 rates to the end use customer. Is this what you mean, 24 or profitability of the entity? 25 MR. ADAMS: Let's take it in pieces. 26 First, what happens to capital structure? 27 MR. EMMET: Fifty per cent is taken 28 off the books. 341 Nepean Hydro Panel 1 MR. ADAMS: So a utility has lower 2 value. 3 MR. EMMET: That's correct. 4 MR. ADAMS: For sale or dividend 5 generation purposes. 6 MR. EMMET: Correct. 7 MR. ADAMS: But you can still sell 8 your utility, you can still generate dividends, you can 9 still operate in a reliable fashion. Is that true? 10 MR. DUPONT: Well, what it would mean 11 for us, for instance, if all our contributed capital 12 was to be taken off the books, in essence, using the 13 nine and three quarter maximum allowed now, it would 14 mean that effectively on our total capital base -- in 15 other words, in our view they are all productive 16 assets, and it would mean that our shareholder could 17 realize a maximum of 3.6 per cent. 18 Yes. I mean we will still be allowed 19 to earn a return, but it will be severely restricted, 20 so the potential is restricted. 21 MR. EMMET: I think specifically yes, 22 the value of the utility would be cut, the economic 23 value of the utility would be cut by about 50 per cent. 24 MR. ADAMS: So today's value drops. 25 Would that drop in value affect reliability in service 26 to customers in any way? 27 MR. EMMET: It ought not to. 28 MR. ADAMS: And you would still be 342 Nepean Hydro Panel 1 able to attract capital, assuming you can get a 2 reasonable rate of return, an efficient fair rate of 3 return on future invested capital. I assume the 4 decision on contributed capital wouldn't impair your 5 ability to attract capital for future investments when 6 they are required. Is that correct? 7 MR. DUPONT: It would seriously 8 impair the benefits to our shareholder and the 9 customers that those shareholders represent. 10 MR. ADAMS: Okay. Maybe I need to 11 understand the distinction between customer and 12 shareholder here. They are not exactly the same group 13 of people. Right? 14 They don't have identical interests 15 when they are wearing their shareholder hat or their 16 consumer hat. Is that correct? 17 MR. EMMET: From my perspective, 18 Mr. Adams, the ratepayers in the City of Nepean are by 19 and large also taxpayers of the City of Nepean. If I 20 was looking for an entity that was in the best position 21 to represent them both, whether you consider them 22 separately or not, I would think the elected municipal 23 council would be in the best position to do that. 24 MR. ADAMS: If the windfall from this 25 commercialization falls to the municipality, is there 26 any guarantee that those benefits are going to flow 27 back to the electricity ratepayer? 28 MR. EMMET: I am not sure that we are 343 Nepean Hydro Panel 1 in a position to discuss the guarantees that a 2 municipality can give, especially given -- I think we 3 have to start from a base or a starting point. 4 Once again, I am very sympathetic to 5 the reasoning that says the not-for-profit entity has 6 kept rates low. It worked in the industry for 31 7 years. I liked the way it worked and I think it has 8 worked very, very efficiently. 9 But the provincial government has 10 made some very specific statements, and whether you 11 consider it a windfall or not, the government's 12 direction is clear that these assets shall be put on a 13 commercial basis and be permitted to earn a 14 market-based rate of return. That is the direction of 15 the government. If you want to debate that I am not 16 the one to debate it with. 17 MR. ADAMS: I am not debating it. I 18 am just trying to decide how much the windfall is. I 19 mean, whether the windfall is real big under a proposal 20 where if you have got -- 21 MR. EMMET: Well, the windfall, if 22 you want to call it a "windfall", I would suggest is 23 the value of the assets, whatever that value is. That 24 is the amount of the money we are talking about, the 25 value of the assets. 26 MR. ADAMS: The OEB has the 27 opportunity today to assign a value here. I mean, they 28 set the starting point. So we are talking about 344 Nepean Hydro Panel 1 whether this is going to be a small amount of money or 2 a big amount of money. 3 MR. EMMET: No, they set the starting 4 point in accordance with the direction of the 5 provincial government, not on a basis of whim or any 6 other measure, in accordance with the direction of the 7 government. 8 MR. ADAMS: Absolutely, and the 9 provincial government says they want the electricity 10 rates to go down. Your proposal would make electricity 11 rates go up. How is that in the public interest? 12 MR. EMMET: Once again, this question 13 of what will happen to electricity rates, the 14 distribution portion of electricity rates: When you 15 say that you are going to commercialize the rate base 16 that was heretofore a not-for-profit entity and that 17 you are going to pay taxes on it, and you have an 18 industry which is very capital intensive -- a number I 19 would pick out of the air, probably on average, I am 20 just guessing, the capital asset base with contributed 21 capital in would probably be about five times the 22 annual revenue requirement of the utility under the old 23 scheme where revenue requirement meant something. 24 The simple math on that, if you 25 commercialize an asset that is five times the revenue 26 requirement -- and use a number, pick a number out of 27 the air; I pick simple numbers because I can do the 28 math: 10 per cent. You could argue it could be 12, 13 345 Nepean Hydro Panel 1 per cent. It is some combination of debt at some lower 2 rate and return to investors, plus taxes at some higher 3 rate. 4 Using 10 per cent on something that 5 is five times the value of the revenue requirement, 6 five times 10 per cent is .5. It means -- this is a 7 back of a cigarette package -- the impact on the 8 distribution portion is about 50 per cent. 9 Now, in Nepean Hydro's case on a 10 monthly bill -- I always like to think in terms of the 11 money coming out of my pocket because it turns out that 12 I am also an electricity consumer, not in my own 13 utility. That is more or less eight bucks a month; add 14 four is twelve bucks a month. Yes, that means the 15 distribution portion of the rates is going up. There 16 is no question. I am not arguing. 17 You are asking is that in the public 18 interest. I am not going to debate that because that 19 is government direction. But I will say that four 20 bucks or $5, or in the case of other utilities it may 21 be more or less, is going two places. 22 One portion of it, in terms of 23 payments in lieu of taxes, is flowing to help pay down 24 the stranded debt and therefore should reduce other 25 portions of the bill. 26 The other part, the part we are 27 interested in talking about now, which is the return, 28 flows to the municipality to do with what it deems is 346 Nepean Hydro Panel 1 appropriate, I would assume. Whether you want to argue 2 that is right or wrong, it may be right or it may be 3 wrong, but again, I am going on the basis of the 4 legislation. This is what we are told is happening. 5 But when you come and then ask the 6 question "does it make sense to set up a differential 7 rate scheme across the province dependent on what the 8 past public policy decisions of utilities have been, so 9 that two otherwise equal municipalities obtain a 10 significant differential rate of return on the assets 11 that the government has indicated they are now to earn 12 a rate of return on", I think that is a serious public 13 policy issue. 14 MR. DUPONT: Could I add one more 15 point. 16 Mr. Adams, the other issue with this 17 is the subsidization between customers. So if you 18 argue, which I believe you are, that past contributed 19 capital ought not to be in the rate base simply because 20 of higher rates, then you have got the issue of what 21 about the customer who obtained a benefit in the past, 22 an aesthetic benefit or whatever? What about that? 23 So there are also issues of 24 subsidization that you have got to, I believe, consider 25 in this. 26 MR. ADAMS: Help me understand that 27 subsidization issue. If the contributing capital goes 28 in at zero, the customer is going to get the benefit 347 Nepean Hydro Panel 1 from it in terms of their lower distribution rate. The 2 dollars don't leave the electricity system. He is 3 going to see enough stranded costs coming down at him 4 from some other charges coming at him from other causes 5 in the electricity system. There is no 6 cross-subsidization going on here. The customer has 7 already paid. 8 MR. DUPONT: I am saying to you that 9 in the past you know why those rates were set, why the 10 contributor capital was levied and what that did to 11 those customers, and what it did to those customers who 12 paid contributed capital in the past obtain lower 13 rates. 14 So now if you say that should not 15 count any more, then if the utility should be sold or 16 if the future rate of return is attractive and it is 17 limited by the contributor capital then what happens to 18 all customers? It is not just the contributor capital 19 customers. What happens to all customers? There is a 20 subsidization issue involved in here. 21 MR. ADAMS: Thank you, gentlemen. 22 There are many things we agree on and some things we 23 depart. 24 MS LEA: I think Board staff had its 25 turn, didn't we? 26 MR. CRONIN: Well, no, you moved 27 before we had a chance to ask the question. 28 MS LEA: We are very tight for time. 348 Nepean Hydro Panel 1 Please go ahead. 2 MR. CRONIN: We have three questions, 3 I think. 4 MS LEA: That could take a very long 5 time. 6 MR. CRONIN: It will be one statement 7 and two questions. 8 MS LEA: Please go ahead. 9 MR. CRONIN: In response to 10 Mr. Adams' statement to the gentlemen from Nepean about 11 the whole issue of rates going down, I think -- and I 12 think Dr. Adamson talked with us when he was with us 13 two weeks ago -- that what we are trying to do here is 14 to price the inputs and the output of the industry 15 efficiently and have all costs reflected and have 16 actors, both those who are procuring capital and those 17 who are buying electricity, face true costs. 18 If that means that rates go up then 19 that is the consequences. But rates should be set on 20 economic costs to drive efficiency into all aspects of 21 the market. 22 MS LEA: Do you have a question for 23 these gentlemen? 24 MR. CRONIN: Yes. Again, the one 25 question is to clarify a discussion that went back and 26 forth which I am trying to sort out myself. I think 27 you said that the rate of return on the assets would be 28 3.6 per cent? 349 Nepean Hydro Panel 1 MR. DUPONT: Yes. 2 MR. CRONIN: Now, if you were trying 3 to go into either the equity or the debt markets to 4 procure capital to effectively run the utility, would 5 your ability to procure that capital be affected by the 6 3.6 per cent? 7 MR. DUPONT: Absolutely, yes, because 8 the banks, I am sure, will look at your 9 revenue-generation capacity and obviously that will 10 affect it. 11 MR. CRONIN: So if your ability to 12 get capital was reduced then would that affect your 13 ability to run the utility well? 14 MR. DUPONT: Yes. 15 MS LEA: Anything further? 16 MR. KING: Thank you. I think there 17 was also a question about a windfall. 18 Is there really a windfall here that 19 is present or are the assets what they are and they 20 were implicitly held in trust? 21 MR. EMMET: Well, I think the past 22 model of electricity distribution was exactly that. 23 They were held in trust for the ratepayers who received 24 a return in the form of lower rates. Nobody was paying 25 a return on any investment, because only the ratepayers 26 in totality had paid for those capital investments. 27 I think it really comes down to a 28 question of semantics. Is it a windfall if a decision 350 Nepean Hydro Panel 1 is made that those assets are to be commercialized or, 2 as you may be suggesting, it is simply reflecting the 3 reality of the cost of capital in rates which has not 4 been there before? 5 The problem that is faced if you 6 commercialize something that is a co-operative is 7 identifying who the owners are and who is going to 8 receive this return. In the case of Ontario the 9 provincial government determined -- and again I think 10 correctly -- that the municipality was in the best 11 position to represent the interests of the people and 12 businesses in their community that pay both rates and 13 taxes. 14 So if it's a windfall on one hand, 15 it's money; and that windfall, if that's what it is, is 16 a return, the taxes going to pay down part of the 17 electricity bill, is available to the municipalities to 18 make appropriate decisions on behalf of the taxpayers. 19 So whether that is a windfall or 20 moving out of one pocket into the other could be 21 debated, as many other things seem to be here, 22 endlessly. But again, the government's direction is 23 absolutely clear: This is the direction we are going. 24 MS LEA: Thank you. 25 Thank you very much, gentlemen, for 26 your presentation today. We appreciate you taking the 27 time to come down and appear at this technical 28 conference. 351 Nepean Hydro Panel 1 MR. EMMET: Thank you. 2 MR. DUPONT: Thank you. 3 MS LEA: I think we will turn back to 4 the OEB panel for a period of time. 5 RESUMED: JUDY KWIK 6 RESUMED: FRANK CRONIN 7 RESUMED: MIKE KING 8 MS LEA: Mr. McKerlie, I think that 9 you still had some questions. Is that correct? 10 MR. McKERLIE: Yes, it is. I will 11 try to be brief. 12 A couple of questions. The first one 13 really is to, I guess, better understand a reference 14 that was made in the handbook. There was reference to 15 the issue of managing rate shock as a result of the 16 transition, the change in the transition costs and 17 restructuring, et cetera. 18 There was a suggestion that a 10 per 19 cent cap -- estimate I understand, a 10 per cent cap be 20 utilized to -- or utilizing deferral accounts to be 21 looked at or, I guess, Board encourages I believe was 22 the wording. 23 I just wonder if I could better 24 understand that a little bit. Was that 10 per cent 25 reference an all in cost? 26 MR. KING: I'm sorry, Mr. McKerlie, 27 could you repeat the question? Just the question. 28 MR. McKERLIE: The whole thing or 352 OEB Panel 1 just the end? 2 MR. KING: Just the question. 3 MR. McKERLIE: Was the 10 per cent 4 reference, to in excess of 10 per cent, was that viewed 5 to be an all in delivered cost of electricity impact or 6 just distribution? Page 3-5, if it helps. 7 MR. KING: I understand. 8 I don't think we really contemplated 9 what the 10 per cent actually meant, was it an all in 10 or was it a specific. It says "based upon service 11 revenue", so I guess it is total. 12 MR. McKERLIE: All in? 13 MR. KING: It was total. All in. 14 MR. McKERLIE: Could you help me 15 understand where that number might have come from? 16 MR. KING: It's my understanding that 17 the Board in previous rate regulation in the province, 18 obviously to gas, has suggested that there might be the 19 need for rate mitigation measures when rate impacts 20 exceeded 10 per cent. So the 10 per cent was simply as 21 a guideline. I don't think it's a hard and fast rule, 22 it's just a guideline the way it was intended here. 23 MR. McKERLIE: Based on your 24 understanding, the way it was presented it's an average 25 10 per cent for the LDC or does it apply to each rate 26 class? 27 MS KWIK: It was actually 28 contemplated as the average for the utility. 353 OEB Panel 1 MR. McKERLIE: Okay. 2 MR. KING: But again, one of the 3 issues here is that we are trying to provide you with 4 the tools to be able to manage the process of if you 5 were having some issues in certain rate classes, if 6 there is a lot of public input and controversy then you 7 may -- you know, you have to craft things to be based 8 upon your own circumstances. 9 MR. McKERLIE: I appreciate that. 10 I'm just trying to -- I have to explain this to others. 11 MR. KING: Sure. Of course. 12 MR. McKERLIE: Those tools are the 13 deferral accounts then? Could you give me some insight 14 as to -- maybe this more of a general regulatory 15 process in terms of the general time. 16 I think you made reference, Mr. King, 17 yesterday, that typically using a deferral account will 18 lead to ultimately a higher rate at some point in time, 19 which is something that we have determined would be the 20 case, depending of course on the term in which a 21 deferral account is recovered. 22 Is there some general guideline 23 associated with that, or do you -- is the guideline 24 then 10 per cent cap per year? 25 MR. KING: One rate mitigation 26 mechanism you have is to defer or forego profits. 27 MR. McKERLIE: I would like to come 28 back to that in a second. 354 OEB Panel 1 MR. KING: Perhaps that's not the 2 only mechanism that is there. 3 MR. McKERLIE: Just specifically with 4 respect to the tools referenced in the handbook, 5 deferral accounts, I think I'm familiar with the 6 concept, but what I'm not familiar with is what a 7 general guiding principle might be in terms of actually 8 recovering the funds in that deferral account. 9 MR. KING: I don't believe that we 10 have any basis on which to give you such guidance at 11 the moment, Mr. McKerlie. 12 MR. McKERLIE: Okay. 13 MR. KING: I would suggest that there 14 may be some experiences out of gas where you could look 15 to try to see how some of these issues have been dealt 16 with in gas regulation. 17 However, I would just caution to a 18 small degree because we are talking about a new 19 circumstance here with many issues that are impinged 20 upon it and clearly these sorts of things would have to 21 be, to a certain extent, negotiated with the Board. 22 MR. McKERLIE: Fair enough. 23 MR. KING: So, you know, I'm not sure 24 it's possible to answer these things before a specific 25 incidence was in front of the Board to be able to work 26 it out. 27 MR. McKERLIE: Fair enough. 28 Just one other question, then, on the 355 OEB Panel 1 10 per cent. 2 Whose forecast of power costs do you 3 think we should use? 4 MR. KING: I could give you a smart 5 answer, which would be PHB Hagler and Bailly's, but 6 perhaps Mr. Adamson wants Frontier Economics. 7 MR. McKERLIE: Don't do that. 8 --- Laughter 9 MR. KING: I don't know. I'm not 10 sure exactly. I have no guidance to provide you on 11 that issue. 12 Perhaps the way to think about it 13 would be to take the existing cost of power and put it 14 in with -- and do it on the basis of the existing cost 15 of power. 16 MR. McKERLIE: Okay. 17 MR. KING: Again, Mr. McKerlie, I 18 think there are some specifics here that you are 19 looking for in terms of guidance that unfortunately we 20 didn't think through so I'm not sure that we have 21 specific answers. 22 MR. McKERLIE: Okay. I guess to the 23 extent, though, that the Board might be utilizing a 24 past practice of 10 per cent and to the extent that it 25 reflects all in cost, probably some guidance in that 26 area would be helpful such that when we put the initial 27 application together we do have a bit of a target and 28 the developmental work that goes into it is consistent 356 OEB Panel 1 with Board's expectations. 2 MR. KING: That's fair, Mr. McKerlie. 3 MR. McKERLIE: In terms of earning 4 market-based rate of return, the reference that you 5 made a couple of seconds ago -- and I have heard 6 reference in the past which respects that. With 7 respect to maximizing market-based rate of return, it 8 is at the discretion of the shareholder. 9 My question would be: Why wouldn't a 10 newly incorporated company want to take advantage of 11 the maximized -- maximize the market-based rate of 12 return? 13 MR. KING: Why would they not? 14 MR. McKERLIE: Right. 15 MR. KING: I think this is one of the 16 interesting points of discussion that I have had 17 outside of this room with many of the participants in 18 the industry. 19 There are certainly some utilities 20 who believe that they are still going to operate under 21 a cost of power sort of basis. Maybe their shareholder 22 has not yet put the screws to him yet. 23 I suspect that there are a variety of 24 factors at work and that pressures are likely to 25 increase soon to see a cash flow out of the 26 distribution utilities due to political decisions about 27 funding local government. 28 MR. McKERLIE: Initially, though, 357 OEB Panel 1 beyond sort of a local political preference to maintain 2 the mandate of power cost, for lack of a better term, 3 you can't see any other -- you wouldn't identify any 4 other business reason why you would want to do that? 5 MR. KING: There are some other 6 business reasons which have to do with the political 7 acceptability of putting through the rate increases 8 necessitated by a market-based rate of return. 9 MR. McKERLIE: Okay. 10 MR. KING: Certainly, I think that 11 many participants in the industry have indicated that 12 there are some issues to be addressed on how you 13 actually are able to implement a market-based rate of 14 return. 15 MR. McKERLIE: By not maximizing it, 16 I guess a question that was asked a couple of minutes 17 ago of Nepean was: How does that impact your ability 18 to operate and attract capital? What is your view of 19 the question that you asked Nepean? 20 MR. KING: I think it is pretty 21 clear. Rating agencies and commercial banks like to 22 see coverage ratios that are high. The higher the cash 23 flow in relationship to debt service the more 24 favourable the ratings and the less costly it is to 25 raise capital. So I think there are definitely 26 tradeoffs that are there. 27 MR. McKERLIE: One question I would 28 have is there is a frequent reference to the fact that 358 OEB Panel 1 you would not have to maximize; it is the shareholder's 2 decision. They have that right and I appreciate they 3 have that right. 4 But should one read anything into the 5 ongoing reference to that fact that the regulator has 6 an expectation that the delivery companies would or 7 should limit their rate of return, I mean beyond the 8 deferral account mechanism, but limit their rate of 9 return to a lower-than-approved level? 10 MR. KING: I think that from the 11 standards of my understanding of the mandate given by 12 legislation to the Board, which is to establish just 13 and reasonable rates, "just and reasonable rates" means 14 that the rates provide the opportunity -- not the 15 guarantee, the opportunity -- to earn the rate of 16 return required by the market to supply the capital 17 necessary to run the enterprise. 18 I personally do not know how one 19 could deem rates as being just and reasonable if they 20 were confiscatory; and by that, that meant that the 21 rates were established at a level where capital had to 22 be provided but could not be provided and sustained on 23 the level of rates that were provided. 24 I think incumbent with that is some 25 concept of a market-based return on the capital -- the 26 opportunity to earn a market-based rate of return on 27 the capital that is deployed. 28 So what does that mean about a 359 OEB Panel 1 utility that decides to operate in conjunction with its 2 shareholder on a power-for-cost basis? I believe that 3 that is certainly their right, and it appears that 4 certain folks in government have been making 5 representations to the municipalities that that is 6 still a possibility. 7 I don't believe that the Board -- my 8 own personal view is that it would be bad policy to 9 institute, from the Board's point of view, a view that 10 results in no less than a market-based rate of return 11 as being a possible outcome of the process. They must 12 have that option. Then the decision whether to 13 exercise the option resides with the utility management 14 and its shareholder, it would seem to me. 15 MR. McKERLIE: I'm wondering what 16 your thoughts would be relative to shareholder 17 direction from some of the other key participants in 18 the delivered price of electricity, i.e. OHSC and OPGI. 19 Would you expect them to accept less than a 20 market-based rate of return? 21 MR. KING: You are asking me for a 22 forecast now and I'm not sure that I would have a basis 23 for the forecast. 24 My understanding is based upon 25 rumours that I have heard about their activities in the 26 possible capital markets. I would find it highly 27 improbable that they would be willing to accept less 28 than a market-based rate of return subject to the 360 OEB Panel 1 constraints that are being placed upon them by 2 government. 3 MR. McKERLIE: Okay. I would agree 4 with you. 5 I guess the suggestion that the Board 6 may -- you suggest it improbable or impractical that 7 the Board restrict a rate of return below that as being 8 market based as opposed -- I mean, providing the 9 guideline and flexibility is one thing. Restricting it 10 would be something else. To do so would in fact be 11 setting the LDC up as the cushion to minimize the 12 impact of electricity changes in Ontario. 13 Would you agree with that? 14 MR. KING: I would agree with that. 15 I think, as the esteemed general manager from Nepean 16 indicated, government has made certain decisions about 17 the future organization of the market and those are 18 not, shall we say, costless. 19 There is no doubt that a 20 transitioning of the market, a more commercial basis 21 and all elements with market-based rates of return, 22 adds a layer of costs that was not previously perhaps 23 present. 24 From an economic standpoint, from an 25 economist standpoint, one would say that that better 26 reflects the deployment of resources in the electricity 27 sector and that because it better reflects the 28 deployment of resources in the sector it will result in 361 OEB Panel 1 better price signals and a better utilization of 2 electricity in toto. 3 In part, the reason why we are 4 embarked on this vast experiment, which has been 5 directed by government to be put in place, is to try in 6 the long run to put the right signals in place so that 7 the right sorts of economic decisions are made. 8 Ultimately, my personal belief, and 9 you can't divorce yourself from this if you are an 10 economist, is that prices do work and that in the long 11 run the Province of Ontario will be better off for 12 embarking upon this experiment. But there is an 13 element of short-term investment for a long-term 14 return. 15 MR. McKERLIE: Thank you. I'm 16 finished. 17 MS LEA: Thank you very much, 18 Mr. McKerlie. 19 Is there anybody besides Mr. White 20 and Mr. Harper who have questions for this panel? 21 The gentlemen from Nepean and 22 Mr. Adams. All right. 23 Is there anybody who has questions of 24 this panel that has to leave before the lunch break? I 25 wasn't sure whether the gentlemen from Nepean had to 26 leave quickly. 27 I can't guarantee that you would get 28 on before three o'clock. I am going to start Mr. Bauer 362 OEB Panel 1 immediately following the lunch break. 2 Mr. White, why don't you go ahead. 3 MR. WHITE: Thank you very much. 4 In the workshop we had in early 5 September, I asked the question about utilities that 6 were going through an expansion phase, and it was 7 suggested that in the paper on mergers and acquisitions 8 there might be some guidance. 9 A preliminary assessment of that is 10 that there isn't any guidance there. 11 Just so that you know that we are not 12 talking about one utility or one customer, there were 13 over 20 -- there were about 20 expansions that have 14 taken place in the last year. These utilities don't 15 have a rate base or a cost base system that represents 16 the customers they serve today. 17 From a conceptual perspective -- and 18 I guess, at this point, I'm now looking to the Board 19 consultants -- if you were trying to build a reasonable 20 case going forward, would you try and reconstruct what 21 would have been the case had the full annual 22 information been available? 23 MR. KING: Basically, we were talking 24 about the case where several utilities were merging or 25 amalgamating. 26 MR. WHITE: No; I'm talking about the 27 case where smaller utilities under previous -- 28 predecessor legislation expanded and assumed control 363 OEB Panel 1 and management of works formerly served by Ontario 2 Hydro. Some of them have increased six to sevenfold, 3 in terms of the customer base, and comparable, if not 4 more substantial, levels in terms of a rate base or an 5 asset base. 6 The unfortunate reality is there is 7 no balance sheet for the customers that were 8 transferred. The only thing that exists prior to that 9 was a balance sheet for the whole Ontario Hydro 10 Services company. 11 MR. KING: So there's no transfer of 12 specific assets with book value? 13 MR. WHITE: There is transfer of 14 specific assets with book value. 15 MR. KING: Okay. So you can 16 construct a -- or you could construct a balance sheet? 17 MR. WHITE: Absolutely. What you 18 can't construct is the operating statement because they 19 don't have a full year's cost of power under the 20 existing rules and you have trouble rolling out and 21 doing the unbundling suggested by the PBR Handbook. 22 I'm looking for some conceptual 23 help -- and I don't want to belabour this ad nauseam. 24 I'm just saying if you were to try and construct what 25 you have reasonable grounds to believe would have been 26 the case, would that be the basis on which you would 27 try and go to the regulator? 28 MR. KING: I think you don't have any 364 OEB Panel 1 other solution. I think you have to try and construct 2 it. Then, in those cases, I suspect there will need to 3 be a fair amount of work, co-operatively, between the 4 rates folks at the Board, with the utility, to try and 5 understand exactly what's being constructed. 6 MS KWIK: I think it is an issue that 7 you should raise, as Mike King says, with our rates 8 section. 9 MR. KING: But for the purposes of 10 more the input into the PBR Rate Handbook, Mr. White, I 11 would suggest that if you have some suggestions about 12 what might happen that you file them in the form of 13 your written comments and oral comments, at the next 14 phase, so that the Board has them on the record and can 15 take them into consideration in the formation of the 16 rate handbooks. 17 MR. WHITE: Thank you. 18 Ms Kwik, you have assured us that 19 there will be changes which will, from my perspective, 20 substantially impact the content of the draft PBR 21 Handbook which is -- and you have alluded to the fact 22 that some of them are being drafted, now, in response; 23 in other words, things like the cost of power 24 reconciliation and items like that. 25 Is there any chance that this 26 information can be made available earlier rather than 27 later? You know, the time pressures that we all are 28 under, not only the Board and the Board's consultants, 365 OEB Panel 1 but all people in utilities, with somewhat complex and 2 unique situations that need to be able to be addressed 3 as quickly as possible. 4 MS KWIK: I think the items that I 5 referred to were those items on which I had received 6 input to let me know that, in fact, I had made some 7 errors in the appendix. So they are more of a 8 corrective nature. 9 In terms of providing any material 10 now, before the Board makes a decision, I would say a 11 utility would be taking its chances. It can either 12 take the current rate handbook and base it on that and 13 take a chance that they won't have to make too many 14 changes if the Board doesn't direct us to make too many 15 changes. Otherwise, they would have to take into 16 account the changes made to the rate handbook. 17 MR. WHITE: Absolutely. 18 Can we expect to see the, quote, 19 corrections come forward before a decision of the 20 Board? 21 MS KWIK: We have been posting 22 corrections on our Web site as we are going along. 23 MR. WHITE: Okay. Thank you. 24 In terms of your opening statement, 25 you indicated that it was a desire, in producing the 26 PBR Rate Handbook, to minimize undesirable outcomes -- 27 and I think that's a correct quote. 28 Can you tell me what those 366 OEB Panel 1 undesirable outcomes might be that you were in pursuit 2 of minimizing? 3 MR. KING: Well, there are several 4 possible undesirable outcomes that might come out of 5 this process. One is bankruptcy -- I don't think 6 anyone wishes to see bankruptcy. Another is uneconomic 7 levels of returns. A third might be a public backlash. 8 Frank, have you got any others? 9 MR. CRONIN: I think the whole issue 10 of competitive balance. We don't want to affect the 11 playing field. 12 MR. KING: Or distort it. 13 MR. CRONIN: Or distort it. 14 MR. KING: But there's a variety of, 15 shall we say, bad outcomes that might occur and have 16 been taken into account in the design. 17 There's also, certainly, the case 18 that one can recognize a bad outcome when one sees 19 it -- and perhaps the perspective on a bad outcome will 20 be different, depending upon who's observing it. 21 Another very important one would be, 22 say, collapse of system reliability, collapse of 23 maintenance; the whole area of service quality. 24 MR. WHITE: Anyone else? 25 Nobody else. Okay. 26 MR. KING: That's probably a good 27 place to start. 28 MR. WHITE: In the dialogue that we 367 OEB Panel 1 have heard put forward, we have seen that there has 2 been a great deal of attention paid to the LDC 3 companies going forward -- and I think the language 4 that I have heard is "in no worse a situation than they 5 are under the existing rules". 6 Has a similar standard of expectation 7 been applied to end-use customers? 8 MR. KING: Well, Mr. White, I'm not 9 sure I would agree with your characterization of the 10 question. 11 I think the "no worse than they were 12 under the existing rules" was with respect to one 13 specific issue -- which happened to be a contributed 14 capital. 15 MR. WHITE: And potentially better 16 off in the other areas where market return is being 17 provided as an opportunity? 18 MR. KING: Or potentially worse off 19 because, after all, the utility then is at risk. We 20 are actually being able to deliver a level of 21 productivity that they generate or they select from 22 Table 4-1, the infamous Table 4-1, and they must 23 deliver that level of productivity or their return on 24 equity will decline, so they are significantly at risk. 25 In terms of whether equivalent sorts 26 of attention have been paid to the ratepayers as 27 opposed to the viability of the utilities, we believe 28 that we have put in place a mechanism which does 368 OEB Panel 1 attempt to strike a reasonable balance between 2 ratepayers and the utility itself. In fact, that's the 3 whole purpose of the PBR scheme, to try and create some 4 incentives to drive further efficiencies into the 5 business. 6 Again, I do wish to say that we 7 believe that the Ontario distribution sector has been 8 relatively efficient, but the PBR scheme is designed to 9 sharpen the incidence to drive further efficiencies 10 into the business, of which ratepayers will benefit 11 through the recapture of some portion of those savings 12 over time. 13 The shareholder may benefit in the 14 short term. In the longer term, the ratepayer benefits 15 and through a specific productivity factor that the 16 utility subscribes to, the ratepayer benefits in the 17 short run. 18 MS KWIK: I would like to comment on 19 your -- I think you were quoting me with the "no worse 20 off", and it was on contributed capital. 21 It was the approach that Board staff 22 had taken which we felt was an approach that leaves 23 both the distributor and its consumers no worse off 24 than they were under the previous regulatory regime. 25 Both perspectives were looked at, the 26 utility as well as the end use customer. 27 MR. WHITE: Is there a level of 28 percentage rate increase in customer bills that would 369 OEB Panel 1 cause a concern from the Board consultant's perspective 2 in terms of individual customers seeing a percentage 3 increase? 4 MR. CRONIN: I guess, you know, it's 5 one thing to speak personally or as an economist and 6 maybe another to speak if you are taking a larger 7 perspective to this. 8 I think the General Manager from 9 Nepean gave some illustrations of the potential for 10 impacts on rates. We are clearly talking somewhere in 11 the range of single digit increases per month, I would 12 assume and while they may be large in percentage terms, 13 they are probably much smaller looked at from an actual 14 rate basis. 15 MR. WHITE: If you were to pick an 16 absolute dollar basis that you considered to be not 17 substantive, where would that dollar level fall out on 18 a monthly basis? 19 MR. KING: Well, let's try it this 20 way. There is no doubt that the changes that have been 21 engendered in the distribution sector in Ontario are 22 going to have significant rate impacts. There is just 23 no way to avoid it. 24 We can talk about what is the source 25 of all those sorts of things. Clearly, a market-based 26 rate of return is likely to by itself cause double 27 digit growth in the rates that are charged to 28 consumers, but as we mentioned before, the Board is 370 OEB Panel 1 obligated under law, I believe, to make an allowance 2 for a market based rate of return. 3 I don't know how one could possibly 4 reach a conclusion that rates were established in a 5 just and reasonable manner if one did not allow for 6 such a potential return. 7 That's not the only issue that we are 8 facing that is going to cause pressure on electric 9 distribution rates in the province. Clearly, the 10 distribution utilities, by the process of the market 11 changes that are occurring and the need to make 12 possible the competitive retailing of energy by other 13 folks to make possible the new commercial relationships 14 between the retailing entities and the IMO and the new 15 entities, Ontario Hydro Services Corporation and 16 OPGI -- all these mechanisms are not exactly costless. 17 One could suggest that we could do a 18 cost-benefit analysis to see whether such costs are 19 reasonable and are in fact cost justified, but in fact 20 such an analysis is moot because the changes have been 21 engendered into law and the utilities have no choice 22 but to respond to them. 23 Whereas in a more traditional rate 24 setting process we might suggest that a rate increase 25 of 10 per cent or 15 per cent or 20 per cent is too 26 large and must be mitigated, in this circumstance I'm 27 not sure that we have such luxury because many of these 28 charges and changes are one time associated with 371 OEB Panel 1 decisions that have been made by government and over 2 which neither the Board nor the utilities have any 3 ability to influence. 4 We are simply left with the result 5 and we must deal with it. Is it likely to be the case 6 that consumers are going to object to the price 7 increases? It may very well be that consumers will 8 object to the price increases, but at the same time one 9 must also recognize that there is likely to be mass 10 confusion in the market in any case as folks try to 11 understand what has been done to the electric sector 12 and are in some senses unable to sort it out. That may 13 create its own issues in dealing with these sorts of 14 circumstances. 15 MR. WHITE: Having heard what you 16 said, is there a dollar value that you would consider 17 not to be material for a residential customer, say? 18 MR. KING: I wouldn't have any basis 19 to be able to answer that. 20 MR. WHITE: Doctor? 21 MR. CRONIN: Well, again, we are 22 starting possibly from the position that the rates were 23 not reflective of the cost of producing the service. 24 That is there is 45 per cent of the cost structure of 25 the utility that is capital and we are currently 26 applying an opportunity cost of essentially 012 per 27 cent to that capital. 28 One could argue that customers have 372 OEB Panel 1 been subsidized for years and that rates should have 2 been higher and that that subsidy that went on for 3 years produced benefits for residential customers and 4 that now the government has decided that we are going 5 to have to reflect the true cost of producing the 6 service. 7 You know, again it's an issue of 8 trying to get the right price signals into the market. 9 MR. WHITE: In the absence of such 10 considerations as a fair market return on capital and 11 the tax implications that might flow out of the 12 incorporation of the municipal utilities, have you any 13 sense of what you think might be a reasonable 14 percentage impact or a dollar impact, in other words, 15 in a normal regulatory kind of environment? 16 I think I heard the 10, 20, 30 per 17 cent numbers flowing out. Is there a dollar level that 18 might be considered to be not material? I think most 19 people could agree that 50 cents isn't material, but 20 there probably is a threshold somewhere that might 21 matter. 22 MR. CRONIN: Again, you know, we are 23 talking about an environment in which many residential 24 customers spend $30, $40, $50 for cable TV. Many 25 residential customers have two telephone lines. 26 I'm not implying that all customers 27 are that way, but there are a significant number who 28 spend far more on discretionary goods than we are 373 OEB Panel 1 talking about they would spend in the difference for 2 electricity distribution rates. 3 MR. WHITE: The customer 4 consideration seemed to me to be, that I read that it 5 was mentioned in the new Ontario Energy Board Act -- 6 are you saying that you really didn't look at the 7 dollars and the percentages on individual customers? 8 MR. CRONIN: Well, we did to the 9 extent that we looked at how distribution rates might 10 increase in total. You know, there are larger 11 questions here which I think you are raising some of 12 the issues and questioning whether or not the market 13 should have been restructured, that they were 14 probably -- 15 MR. WHITE: No, sir. I am not 16 questioning that. I am just trying to get some 17 quantities on what the dollar and percentage impacts 18 might be on end-use customers with or without the 19 market restructuring. I am not trying to say that the 20 market shouldn't have been restructured. It is a 21 reality. 22 MR. KING: Let's try it this way. To 23 try and answer your specific question about what is a 24 reasonable amount to raise rates by or when does it 25 become unreasonable, I think it depends upon the 26 context. 27 Obviously, if you are in a 28 highly-inflationary environment where natural gas 374 OEB Panel 1 prices are escalating at 8 per cent per year, you can 2 probably get an 8 per cent, 10 per cent rate increase 3 through because of the context of everything else that 4 is changing. 5 So here if we are talking about this 6 circumstance where we have a substantial amount of 7 costs that are being imposed upon the utilities and the 8 obligation to allow a market-based rate of return 9 should the utility and its shareholder decide to 10 exercise that right, there is the possibility that such 11 changes, even though they may be large in absolute 12 terms, maybe 30, 40, 50 per cent, can be explained in 13 such a way that they are accessible. 14 Not only that, it also has to do with 15 an issue of how much people will actually be able to 16 sort out what is changing in this sort of environment. 17 If there is not a lot of other change that is going on, 18 obviously they are going to be much more sensitive to 19 the issues than if they can't figure out why Enron is 20 calling -- oh, I shouldn't use a specific name -- why 21 XYZ power marketer is calling them at 5:00 p.m. trying 22 to sign them up for electricity supply. I mean, I 23 thought Toronto Hydro was my utility. 24 Many of these things may be more 25 acceptable -- or I shouldn't say more acceptable, but 26 less attention may be paid to them because of all of 27 the other changes that are ongoing. 28 So I don't think that it is possible 375 OEB Panel 1 to answer your question with specific numbers. 2 MR. WHITE: Miss Kwik, in a former 3 life I think you were involved in regulation within 4 Ontario Hydro? 5 MS KWIK: That's right. 6 MR. WHITE: Without the changes and 7 implications associated with tax and a fair market 8 return, and without significant caps being placed on 9 the IDC component or the component that is recovered in 10 the ongoing energy rate, what were the highest 11 percentage impacts that you saw when service charge 12 rates were considered for the introduction on a 13 percentage basis, for say the minimum bill customer? 14 MS KWIK: Are you referring back to 15 the research that was done at Ontario Hydro? 16 MR. WHITE: Yes. 17 MS LEA: I am sorry. I can't hear 18 your answer. 19 MS KWIK: I was asking whether he was 20 referring to the research that was done by Ontario 21 Hydro. 22 I was not involved in that research. 23 I did read the report but I can't remember. I don't 24 know the exact maximum impact but I do know that you do 25 get within the residential class a higher impact on the 26 low user. I believe you were involved and perhaps you 27 remember the -- 28 MR. WHITE: If I was to suggest to 376 OEB Panel 1 you that reading substantially more than 6.2 mils in 2 the energy component would produce impacts in the order 3 of 70 to 120 per cent on individual customer bills, 4 would you find those numbers surprising? 5 MS KWIK: Yes, I find them rather 6 surprising. I would have seen that if it was a low 7 user it might be high. I think because we did not have 8 the data individually until today to do that research 9 ourselves, we did put in the rate outlined that we 10 wanted the utilities to take that into account. 11 MR. WHITE: Within the residential 12 class I would suggest you did have the data; but okay. 13 MS KWIK: I am sorry, I do not. Not 14 since I have been working at the Board. 15 MR. WHITE: Okay. 16 Can we talk for a minute about 17 losses. From a technical perspective, what causes 18 losses in an electrical distribution utility? 19 MS LEA: Financial or line losses? 20 MR. WHITE: Line losses, technical 21 losses. 22 MR. KING: There is both technical 23 losses and loss due to theft, diversion and -- 24 MR. WHITE: I am more interested in 25 the technical area right now. 26 MR. KING: Right. Well, there are 27 thermal losses and there are transformer losses. 28 MR. WHITE: Okay. 377 OEB Panel 1 MS KWIK: I believe you are an 2 engineer, if you want to expand on that. 3 MR. WHITE: There are fixed losses 4 that are there regardless of the energy consumption 5 associated with lines, the very fact that you are 6 keeping a transformer warm and a conductor is 7 energized. As consumption goes down, energy sales go 8 down, what would happen to the losses as a per cent of 9 the sales for the fixed loss component? 10 MR. KING: Well, losses rise at the 11 square of energy deliveries occurring. So it is -- 12 MR. WHITE: I am asking now 13 specifically about the fixed component, the component 14 that is there regardless of whether the power is being 15 consumed. 16 MR. KING: Since it is fixed, it is a 17 linear relationship. 18 MR. WHITE: It would grow as the 19 energy sales fall? 20 MR. KING: Right, exactly. 21 MR. WHITE: Thank you. 22 If a utility has a more distributed 23 distribution system, is it likely to have higher losses 24 or lower losses than a more concentrated densely 25 populated service area? 26 MR. KING: Higher. 27 MR. WHITE: Can we look for a minute 28 at the 6.2 mils IDC that seems to be very important. 378 OEB Panel 1 Are you aware that that was a 2 residential-only IDC? 3 MR. KING: I think we have stated 4 earlier we have no background or information on the 5 derivation of that number. 6 MR. WHITE: Would it surprise you 7 that was a component that was in the residential 8 end-rate test, I think, of the day -- 9 MS KWIK: No, I didn't know that it 10 was in the residential end rate. 11 MR. WHITE: Was there a percentage 12 difference between the residential end rate and the 13 typical commercial rate? 14 MS KWIK: Well, what we have heard 15 from some of the stakeholders is that, yes, you could 16 expect that the IDC would be different for different 17 classes. That is why there is the option for utilities 18 if they have their own data to use that with 19 justification. 20 MR. WHITE: If a utility, let's say 21 smaller or less than 10,000 customers, were to not have 22 the ability to hire high-priced analysts and were to 23 use the direct data in the PBR Handbook, what would 24 happen if the IDC, the true IDC for the utility, were 25 substantially above the 6.2 mils? 26 Where would that revenue requirement 27 flow? 28 MS KWIK: The way it is structured, 379 OEB Panel 1 Appendix A, the methodology in Appendix A, we have 2 it -- we have the calculations in such a manner that 3 the utilities when they go to this unbundling method 4 stay revenue neutral at a class level. And as I stated 5 in our opening remarks, the reconciliation steps had 6 not been included in Appendix A but will be. 7 MR. WHITE: Given that, would the 8 dollar shortfall that was not recovered from the IDC 9 not flow into the service charge within the class? 10 MR. KING: I guess I don't understand 11 the premise of your question. 12 MR. WHITE: Well, rightly or wrongly 13 I have tried to work with the PBR Handbook and design 14 some end use rates flowing from it that would impact on 15 even simply the easy one to get at, the residential 16 class. What happens is that when you subtract out the 17 losses from the IDC, then the rest of the money you get 18 from the IDC helps to offset the distribution costs and 19 everything else that is required flows into the service 20 charge. 21 Am I doing something wrong? 22 MR. KING: No, that's correct. 23 MR. WHITE: Okay. Thank you. 24 Now, the 6.2 mils that was in the IDC 25 residential end rate test in the model that you are 26 referring to, was that residential end rate test a 27 floor, a ceiling or a mandatory rate? 28 MS KWIK: It's a default that we are 380 OEB Panel 1 suggesting if you don't have your own IDC data -- 2 MR. WHITE: No, I mean in the -- like 3 you are grabbing it from a 1980 study that was done by 4 Ontario Hydro. At that point, the residential end rate 5 that came out of that test, was that the floor, the 6 maximum or the mandatory price? 7 MS KWIK: I believe at one point it 8 was not a floor or a max, but the guidelines had 9 changed in recent years so that it was a floor. 10 MR. WHITE: I see. 11 And where do most existing utility 12 end rates compare with the test level? 13 MS KWIK: I can't really comment on 14 that. I have been away from it for a while. 15 MR. WHITE: If I suggested to you 16 that they were 3 per cent higher than the test value, 17 would that surprise you? 18 MS KWIK: No, that would not surprise 19 me. 20 MR. WHITE: If that 3 per cent is 21 intended to recover what is more closely represented as 22 the IDC cost within the class, that would require an 23 increase of over 30 per cent in the IDC. Does that 24 surprise you at all? 25 MS KWIK: Let me follow the math. 26 MR. WHITE: I won't say "trust me" 27 because I don't want to go there. 28 For those utilities that are not 381 OEB Panel 1 currently getting a "fair market return" on the rate 2 base, where will -- let's talk about the residential 3 class and assume that it is being apportioned in some 4 fashion. 5 Where will that incremental revenue 6 requirement flow in terms of the rate design within the 7 PBR Handbook? 8 MS KWIK: Let's see. When you do 9 your adjustment for rate of return you do it on the 10 class revenue distribution revenue requirement, and 11 then you would go through the steps as outlined in 12 Appendix A, if that is the way you choose to go. 13 So it really would get, I think, 14 apportioned proportionately to service -- some of it 15 will go into the throughput and some of it goes into 16 the monthly service charge, I think. 17 I haven't really tried it, but just 18 thinking -- 19 MR. WHITE: I wasn't able to 20 interpret that from the handbook so maybe that is 21 something that we can look forward to seeing some 22 evidence of in -- 23 MS KWIK: The adjustment of rate of 24 return on the class distribution revenue requirement? 25 MR. WHITE: Yes. 26 MS KWIK: Okay. 27 MR. WHITE: As to whether that would 28 in fact be applied to the IDC as well as opposed to all 382 OEB Panel 1 flowing into the service charge. 2 MR. KING: I believe under the 3 current proposal it would all flow into the service 4 charge. 5 MR. WHITE: Thank you. 6 That was my interpretation trying to 7 follow what I thought was in the PBR. 8 MS KWIK: I agree. Yes, that's 9 right. 10 MR. WHITE: Okay. 11 Similarly, incremental taxes that 12 might be paid by the utility, where would they flow? 13 MR. KING: Well, since they are all 14 part of the market-based rate of return adjustment, 15 they also flow into the monthly service charge. 16 --- Pause 17 MS LEA: Mr. White, I should call a 18 lunch break soon and I have two things that need to be 19 done before that. Can you give me any indication -- 20 MR. WHITE: This is a good place to 21 break, if you want to. 22 MS LEA: Okay. Can you give me an 23 indication how much longer you will be? 24 MR. WHITE: Twenty minutes, half an 25 hour. 26 MS LEA: I see. All right. Well, 27 then we had better take care of a couple of 28 administrative matters. 383 OEB Panel 1 Two things. 2 First, Ms Kwik, I understand you have 3 a transcript correction. 4 MS KWIK: That's right. 5 MS LEA: Is that correct? 6 MS KWIK: Yes. 7 MS LEA: Give us the page and an 8 opportunity to turn it up, please. 9 MS KWIK: Okay. The transcript page 10 18, lines 18 to 22. 11 MS LEA: Please speak up and go more 12 slowly. 13 Page 18, lines 18 to 22 I think you 14 said? 15 MS KWIK: Yes. That is our opening 16 remarks. 17 I had taken for 1993 to 1997 the TFP. 18 I had mixed up the numbers for the median and the 19 average. It should be the median was 1.97 per cent and 20 the average was 2.05 per cent. 21 MS LEA: I understand the figures as 22 listed on the exhibit, though, are correct? 23 MS KWIK: They are correct. 24 MS LEA: Thank you. 25 The second matter I wanted to deal 26 with is that Mr. Emmet has indicated that he has only 27 one question for this panel and promises that he will 28 be very brief, so I would like to give them the 384 OEB Panel 1 opportunity, since they have to leave immediately after 2 lunch, to come forward and ask that question. 3 My apologies to Mr. White -- 4 MR. WHITE: No problem. 5 MS LEA: -- but people's schedules 6 are tight today. 7 MR. EMMET: Thank you very much. 8 Did I really say I would be brief? 9 MS LEA: I don't think you did, sir. 10 I think you just promised me one question and I made 11 that assumption. 12 MR. EMMET: One question, but a 13 47-page preamble. I hadn't mentioned that. 14 I just want to really understand: 15 You have indicated that you are not capable of 16 guaranteeing the future. Is that correct? 17 --- Laughter 18 MR. KING: Well -- 19 MR. EMMET: Yes or no? I'm learning 20 how this game is played. 21 Yes or no? 22 MR. KING: No. No. 23 MR. EMMET: No, you can't guarantee 24 the future, okay. 25 Do you consider generation one PBR to 26 be essentially a two-year or three-year learning 27 experience? Is that your concept? 28 MR. CRONIN: Yes. 385 OEB Panel 1 MR. EMMET: Okay. There appears to 2 be a great deal of concern regarding the establishment 3 of appropriate input price index and productivity 4 factors. My suspicion is that, all other things being 5 equal, consumers groups would argue for a higher 6 productivity factor and shareholders were argue for a 7 lower productivity factor. 8 Now, I understand that these are 9 complex issue but I am a simple person so I want to ask 10 a simple question: I would like to understand the 11 consequences of you folks being grossly in error in 12 your assumptions regarding IPI and productivity 13 factors. 14 So essentially what would happen if 15 an LDC conscientiously attempts to achieve the 16 productivity target but falls short, how far short. 17 What would be a worst case circumstance? The proposed 18 productivity factor for discussion purposes is 9.75 per 19 cent and input -- I'm sorry, 1.25 per cent? I get 20 confused with the rate of return. 21 That's correct, 1.25 per cent? 22 MR. CRONIN: Right. 23 MR. EMMET: And an input price index 24 which may -- is proposed not to be the CPI. 25 But let's say that you were way, way, 26 way out of line and us folks missed by what, a full 27 percentage point. In other words, essentially 28 productivity improvements disappeared almost. 386 OEB Panel 1 What would be the result year one in 2 an interim transition period, when 9.75 per cent rate 3 of return is allowed. On that basis we have set a 4 price, but we miss on the productivity. We don't get 5 that, and 1 per cent disappears. 6 What happens to the return a utility 7 is likely going to see? 8 MR. CRONIN: The return would fall 9 somewhat. 10 MR. EMMET; Do you have a sense, 11 would it be one for one more or less? 12 MR. CRONIN: We can actually answer 13 that specific question. Talking off the top of my 14 head, it would be equal to or less than the 1 per cent. 15 MR. EMMET: So if you people are 16 horribly wrong in a two year transition period my 17 shareholder may not be able to realize 9.75, they might 18 see only 8.75. 19 Is that more or less what you are 20 saying? 21 MR. CRONIN: Right. Subject to our 22 actually checking the number, yes. 23 MR. EMMET: Okay. 24 Like I say, my suspicion is that some 25 people in competitive markets around the world, say 26 Eaton's and many others, probably would accept a 27 transition period where you were not guaranteed, but 28 ensured a relatively risk free 8.75 instead of 9.75. 387 OEB Panel 1 So if you will allow me a 2 hypothetical, given that our friends here and perhaps 3 no one else is likely to be able to accurately predict 4 the results of any proposed regime going forward, and 5 given the apparent, at least to me, less than draconian 6 consequences of being substantially wrong during a 7 two-year transition and learning period, I just put it 8 out there for contemplation: How long should we go 9 around the mulberry bush on input price and 10 productivity factor before we make a decision? 11 And I will just leave it at that. 12 Thank you. 13 --- Laughter 14 MR. CRONIN: We will calculate that, 15 Mr. Emmet. 16 MS LEA: I'm sorry, you are going to 17 calculate the exact figure? 18 MR. CRONIN: No, just double check 19 that our statement is correct. 20 MS LEA: All right. 21 --- Laughter 22 --- Off record discussion 23 MR. KING: Although we can't 24 guarantee the results. 25 MS LEA: Thank you very much, 26 Mr. Emmet. We appreciate your contribution. 27 We will break now for lunch. And 28 unless this inconveniences people horribly, we will 388 OEB Panel 1 reconvene at quarter to 2:00. That is a bare hour. 2 We will be commencing with 3 Dr. Bauer's testimony at that time. 4 --- Luncheon recess at 1246 5 --- Upon resuming at 1344 6 MS LEA: Are we ready to commence? 7 --- Pause 8 MS LEA: All right. I think we have 9 with us Dr. Bauer. 10 I think, Mr. Warren, you are 11 presenting Dr. Bauer on behalf of several intervenors? 12 JOHANNES BAUER 13 MR. WARREN: I'm presenting Dr. Bauer 14 on behalf of one intervenor, the Consumers Association 15 of Canada. 16 A couple of things by way of 17 pre-preliminaries, Dr. Bauer. 18 You have delivered, on behalf of my 19 client, some written comments on the proposed Electric 20 Distribution Rate Handbook, and it does not contain any 21 indication of your curriculum vitae. 22 I wonder if you could very briefly 23 indicate for those who do not know you -- as limited a 24 number as that might be -- what your current position 25 is and briefly sketch your background. 26 MR. BAUER: I am currently an 27 Associate Professor in the Department of 28 Telecommunications at Michigan State University. I am 389 OEB Panel 1 also a Research Associate at the Institute of Public 2 Utilities at the same university. 3 I have, between 1993 and 1998, served 4 as the Director of the Institute of Public Utilities at 5 Michigan State University. I have since decided to go 6 back to my pure academic position. 7 I have in my function as the Director 8 of the Institute of Public Utilities authored papers 9 and given a number of presentations and appeared in a 10 number of proceedings related to utility restructuring 11 incentive regulation and related issues of public 12 utility regulation. 13 MR. WARREN: Dr. Bauer, have you, as 14 well as that background, appeared as both a witness 15 before this Board dealing with, among other matters, 16 performance-based regulation and also acted as a 17 consultant to the Board on issues of public -- this 18 Board -- on issues of performance-based regulation? 19 MR. BAUER: Yes, I have. 20 MR. WARREN: Okay. 21 With that background behind us, Dr. 22 Bauer, I would like you to turn to the comments which 23 you have filed, and I would ask you if you would please 24 summarize for us what you believe are the key issues. 25 MR. BAUER: I would be pleased to do 26 so. 27 It is important when thinking about 28 performance-based regulation, in price cap design in 390 OEB Panel 1 particular, to get three components, I think, of such a 2 plan in good shape. 3 One is the identification of the 4 correct starting point of initial rates upon which a 5 plan is based. 6 The second issue is, in the case of 7 price cap design, the indexing formula that is chosen. 8 The third aspect I think is the 9 ancillary dimensions of the performance-based 10 regulatory regime, such as monitoring provisions, 11 Z-factor adjustments and other things. 12 It is my sole opinion that looking at 13 the work that is before us so far in the staff proposed 14 Electric Distribution Rate Handbook, a material that 15 has been posted on the Web site, that very valuable 16 work has been done with respect to identifying the 17 correct indexing approach and also the ancillary 18 components of the plan. 19 I have some specific comments on some 20 of the design features that I would like to share in 21 just a minute. 22 Less attention, in my view, has been 23 paid to what seems to be the overreaching and perhaps 24 in the long run even more important issue, and that is: 25 Where do we start from? 26 I understand clearly that the process 27 is driven by a legislative mandate and there are 28 certain parameters that the Board and the Board staff 391 OEB Panel 1 cannot influence. 2 However, I think in the current 3 approach, where in the near future those 270-plus 4 utilities are asked to file an initial rate 5 application, an incredible amount of trust is placed on 6 the data that they submit as the starting point for the 7 process. 8 There are two components of 9 insecurity I think. 10 One is that we do not know exactly 11 what the accuracy of the data is that are available. 12 If one can make any assessment based on the experience 13 of the task forces in other areas, then it seems that 14 there is a fairly high degree of uncertainty as to how 15 accurate the data is at this point in time. 16 Secondly, the utilities are given a 17 fairly large range of discretion it seems in terms of 18 proposing: (a) transition costs that they have to 19 incur in terms of migrating to the new, more open 20 regime; and also in terms of some more specific plan 21 parameters such as the basket design and other things. 22 But let me focus on the initial 23 aspects. I think there is an incredible risk -- I 24 almost look at this as a time bomb -- that we 25 miscalculate the starting point. So it seems that a 26 lot of the debate focusses on the relatively marginal 27 impacts that we have for fine-tuning the indexing 28 formula over a three-year period, but they don't 392 OEB Panel 1 address the big issue and that is: Where do we start 2 from? 3 There are several ways that one could 4 address this issue. 5 One would be able to do a growth rate 6 for cost allocation in the rate case process. I think 7 everybody is of the opinion that this would be too time 8 consuming and, given the large number of utilities, 9 would be impractical. 10 I think there are second-best 11 solutions, and I would be glad to address those in more 12 detail. But I think it would be at least important 13 that the Board put some structural safeguards into 14 place to minimize the risk that the numbers presented 15 in those initial rate applications are off target. 16 Examples of such procedural 17 safeguards could be the requirement that data be 18 audited rather than the utility's own submission. 19 Please keep in mind that I don't want 20 to imply fraudulent management practices or anything. 21 My analysis is really based on an assessment of what 22 kind of incentive does the legal regulatory framework 23 create. That is really what the entire body of 24 incentive regulation is based on. 25 Secondly, when it comes to transition 26 costs, I think there could be other procedural 27 safeguards. For example, the utilities are required to 28 beat out certain projects, certain capital projects, or 393 OEB Panel 1 that there is a clear requirement in place that after 2 the three-year period there will be a prudence review 3 of these capital investments as far as they are 4 declared as transitory investment needs. 5 I think such measures, and the other 6 options that would be feasible, would help us obtain 7 one thing and that is they would help mitigate the 8 incentive that every utility, given the current 9 framework, has to inflate its initial costs. 10 Now, every utility under the current 11 structure, the way the PBR plan is set up, the way the 12 data submission works and the way the review is 13 designed, has a very strong incentive to declare costs 14 that are as high as possible. This is actually 15 compounded by the fact that some utilities seem to 16 envision a sale of their assets to private investors. 17 All these facts really have an inherent tendency to 18 inflate these initial submissions. 19 I don't think that the process in 20 place and the time structure in place, where you have a 21 very tight-knit time schedule to review those 22 applications, will allow to identify anything but gross 23 abuses. Therefore, I think there is a high risk that 24 the initial plan parameters may be mistaken. 25 Now, having said all these things, I 26 think my preference, as I indicated in the paper, would 27 be to perhaps stretch this initial time period somewhat 28 and allow more time before the first phase of the price 394 OEB Panel 1 cap plan takes effect. 2 I didn't want to suggest, as some 3 have indicated in comments that I received, to postpone 4 the price cap regime for a very long time. I certainly 5 didn't want to suggest to move to other than the 6 two-phase price cap proposal. 7 I think the idea to allow a first 8 phase of a price cap regime that would help generate 9 the operational data that are required to engage in 10 meaningful yardstick and benchmarking, that data could 11 not be generated in half a year or in a year's time 12 frame. I think the three-year period is a meaningful 13 compromise in that respect, and I think that perhaps a 14 transitory stage to a second and more refined set of 15 performance-based plans could differentiate in -- 16 depending on the size of the utility, perhaps obtain a 17 price cap regime for the larger ones and then move to 18 benchmarking or yardstick regulatory model for the 19 smaller utilities. 20 I think strongly, though, that the 21 time frame, the starting post, to a certain degree, is 22 very risky, with respect to the determination of the 23 starting conditions of the plan. 24 Now coming to the plan design more 25 specifically -- let's assume we have not clarified this 26 overarching issue which certainly, in the long run, has 27 much higher impact than the fine-tuning of the plan. 28 Let me highlight a few conclusions 395 OEB Panel 1 that I come to in this respect to the proposed price 2 cap proposal. 3 It would be desirable -- and some 4 people have suggested this -- to build some information 5 on efficiency differences into the plan. I have heard 6 several times, in the material posted on the Web site, 7 that the data is insufficient. I'm not certain that 8 this is the case where the Board couldn't still try to 9 come up with some differentiation of the plans, such 10 that the efficiency levels of the utility would be 11 reflected in the menu of choices that they can choose 12 from. 13 Second, I can only re-emphasize that 14 we need to look at transition costs with great caution. 15 I would like to see more assurances 16 that the rates that are put into place are subsidy 17 free. 18 Again, it seems that the data is 19 inaccurate -- or at least we don't know how inaccurate 20 it is. Some of the data is very old and it's almost 21 like playing the lottery. Now, the data based on 22 1980's operational characteristics can be accurate but 23 we don't even know the likelihood with which they are 24 accurate, so it would be good to update those. 25 I have some concern about the menu of 26 choice that I indicated. I'm not sure exactly how it 27 was calibrated -- and I think we learned a little bit 28 more this morning what the pragmatic approach to it 396 OEB Panel 1 was. 2 I saw too little with respect to the 3 basket design. It seems to give a very large amount of 4 discretion as to what kind of baskets they propose. 5 And that may or may not become a back door to practices 6 of rate re-balancing that either may lead to 7 cross-subsidies, or at least discriminate against the 8 smaller customers. 9 So perhaps some more guidance to the 10 utilities, in that area, would be desirable. 11 Given the high degree of uncertainty, 12 at least in the first phase of the price cap plan, I 13 also found that to have some symmetric sharing 14 structure would be more desirable, because it has 15 different risk-mitigating features compared to the 16 current asymmetric one that is in place. 17 I emphasize in my paper that if there 18 are large investment projects that are necessary, the 19 price cap model is not a good tool to deal with those; 20 there would have to be additional provisions for such 21 projects. 22 I talk briefly about the service 23 quality issue, essentially, arguing that all the 24 indicators should be reported and subject to some 25 review. 26 I notice that the monitoring 27 provisions, I think, need to be further developed. 28 It is not clear, in my view, how on 397 OEB Panel 1 an annual basis the compliance with the price 2 constraints is marginal, though I understand the 3 compliance with the rate of return constraint, how this 4 is marginal.. 5 I should mention, by the way, that I 6 have overlooked the fact that, in the supplementary 7 handbook, the staff proposes a method how to take care 8 of over-earnings, which my paper doesn't speak to that 9 and I modify my remarks in that respect. 10 Last, but not least, I think the 11 parameters for the plan review after three years are 12 too generic at this point. Actually, one of the ways 13 to take care of the incentive to overstate costs than 14 submitting initial rate applications would be to make 15 clear, at this point in time, how the review will 16 happen three years down the road. 17 If there was a very clear assumption 18 in place that utilities, in the beginning of the price 19 cap, that overstate the costs will face some sort of 20 negative consequences because they will in three years 21 be benchmarked against the best practice utility or the 22 medium utility -- we can discuss the specifics -- I 23 think the incentive to overstate costs will be reduced 24 ahead of time. 25 So I think that these two issues are 26 linked. 27 If we can come up with clear 28 provisions as to the review process at the end of the 398 OEB Panel 1 three-year period, I think we can mitigate or even 2 eliminate some of those negative incentives that I 3 spoke of in the beginning. 4 These are, in a nutshell, my main 5 points and I would be glad to answer further questions. 6 MR. WARREN: I have three areas, 7 additional areas, briefly, that I want to cover with 8 you, Dr. Bauer. 9 The first is an issue which was the 10 subject of -- the principle subject of the remarks by 11 the representatives of Nepean Hydro, this morning; and 12 that is, the issue of contributed capital. 13 Your view on that issue is what? 14 MR. BAUER: I think I make it clear 15 in my written submission that I believe strongly that 16 every capital item should bear an opportunity cost as 17 an economic principle, although I have to admit that 18 given the fact of public ownership in the past and the 19 specific constraints under which utilities operated 20 made financing through a contributed capital very 21 attractive to some of them. 22 I think, though, in thinking through 23 this issue, there are two perspectives: one would be 24 to look at contributed capital as capital provided by 25 investors-slash-ratepayers -- slash-owners, in some 26 cases. If that is the case, then these people should 27 earn a return on their funds. 28 In other words, the question is how 399 OEB Panel 1 do they get this return? 2 In the past, I think the fact that 3 the rates were kept low was nothing else but an 4 implicit form of paying these investors some return. 5 The other way would be to simply look 6 at it as an advance payment of funds -- and it's 7 difficult to say on which side one comes down. 8 I think that in the long run, 9 though -- contributed capital, I think, is an anomaly, 10 if one has division of a privately-owned commercialized 11 distribution industry and I think, therefore, that the 12 idea of excluding it on the forward-looking basis from 13 the rate base is the right idea because it forces 14 utilities to look for other sources of funds, debt 15 capital, equity capital and so on. 16 Regulatory changes always face the 17 difficulty of what do we with past established rules 18 and decisions, and the biggest danger, I think, that 19 regulators face is to lose credibility by engaging in 20 acts of regulatory recontracting, that you change rules 21 retroactively. 22 And for that reason alone, and not 23 for any overarching economic reasons, I think that the 24 proposed model of leaving past contributed capital in 25 the rate base to the extent of a return in the past is 26 a feasible transition method. I actually, in essence, 27 agree with the solution that has been proposed in the 28 handbook. 400 OEB Panel 1 MR. WARREN: The second area I wanted 2 to deal with Dr. Bauer, was the issue of whether or not 3 you have any concern about the impact, particularly, on 4 small consumers, residential consumers, of the loading 5 of fixed charges onto them? 6 MR. BAUER: In general, pricing 7 structures that introduce flat charges or per-head 8 charges tend to have regressive effects. In other 9 words, customers who have lower uses or smaller uses 10 will be affected over-proportionately -- 11 MS LEA: That was regressive effect? 12 MR. BAUER: Yes, regressive. 13 MS LEA: Thank you. 14 MR. BAUER: Which means that smaller 15 customers are affected more. 16 You know, you gave some examples as 17 to what the effect could be. It's difficult from these 18 examples to get a view as to what the change would be 19 from the concentration to the new scenario. 20 This argument is really based on the 21 genetic analysis of the effect of introducing a flat 22 rate component. My concern, with respect, is that 23 smaller customers and those customers who have the 24 least choice options would be hit harder. I think it 25 would be feasible to differentiate perhaps the flat 26 charge based on some measure that reflects the size of 27 consumers. 28 I think it could be hypothesized that 401 OEB Panel 1 the distribution service charge is related to the 2 consumption of consumers, and perhaps one could 3 differentiate that component of the charge based on the 4 consumption and in this way avoid the regressive effect 5 of a flat charge. 6 MR. WARREN: Well, the last point I 7 want to deal with, Dr. Bauer, was to circle back to a 8 point that you began with, which is your concern about 9 starting at the wrong starting point. 10 I wonder if I could just ask you the 11 question: Does starting at the wrong starting point (a) 12 have long term effects; and (b) if so, how serious can 13 those effects be? 14 MR. BAUER: Experience tells me that 15 starting at the wrong point by initial rates probably 16 has fairly long lasting effects. I mean there's a 17 certain self-healing tendency in incentive plans. Over 18 time mistakes will be worked out. Mistakes will be 19 worked out the faster the industry becomes a more 20 competitive industry, which we cannot expect in the 21 context of the distribution industry. 22 Mistakes early on may have a tendency 23 to last. 24 Of course, there is the plan to 25 rebase the price caps for the second plan period. The 26 major concern I have is that rates that are put into 27 place during the first period will become precedents 28 and will not be easy to change in the second phase. 402 OEB Panel 1 I am worried both conceptually, 2 because mistakes at this initial stage will be 3 compounded over the first plan period, but also in 4 practical political terms, as to how feasible it would 5 be even if you were able to detect mistakes, to correct 6 those in the rebasing of the plan. 7 MR. WARREN: Thank you, Dr. Bauer. 8 MS LEA: Thank you. 9 Can I ask who has questions for 10 Dr. Bauer. 11 A goodly number of folk then. 12 We will start then with Mr. Rodger, 13 please. 14 MR. RODGER: Thank you, Ms Lea. 15 Just a couple of questions, 16 Dr. Bauer. 17 Firstly, going to your paper, and 18 this is under the section -- the reference is page 7. 19 It's under the general theme of "Prospects and limits 20 of performance based regulation". 21 If I could just refer you to the last 22 full paragraph of that section on page 7. It reads: 23 "Second, PBR methods were 24 developed to overcome the 25 information asymmetries of 26 regulators when dealing with 27 privately owned utilities. The 28 incentive effect of all forms of 403 OEB Panel 1 PBR critically rests on 2 management's goal to increase 3 the profitability of the firm. 4 There is no systematic 5 experience with PBR in a public 6 ownership setting. It can be 7 doubted whether the desired 8 efficiency-stimulating features 9 of PBR can be translated into 10 public ownership. For this 11 reason, caution is needed when 12 forming expectations as to the 13 efficiency implications from the 14 introduction of PBR." 15 I wonder if you could just perhaps 16 flesh out what the fundamental concern is here and 17 specifically what's the basis of your assertion that it 18 should be doubted whether the desired efficiency 19 stimulating features of PBR can be translated to public 20 ownership. 21 MR. BAUER: First of all, I don't say 22 that it's impossible. What I am saying is that the 23 intellectual body of research that is underlying 24 incentive design assumes, in most cases tacitly, that 25 management is driven by maximizing profits for the 26 private shareholders of the firm. 27 As we have heard in statements 28 earlier today and is widely known from the operations 404 OEB Panel 1 of management of publicly owned enterprises, very often 2 their system of goals is more differentiated, more 3 complex than profit maximization. Therefore, incentive 4 schemes that are designed to achieve efficiencies in 5 the context of private enterprise management may not 6 translate well into these more complicated settings. 7 Now, that doesn't mean it is 8 impossible. I think one could envision a situation 9 where even though in public ownership these incentives 10 plans could work out, it would require though a very 11 clear management philosophy that is oriented towards 12 maximizing profits of the firm. 13 I'm not sure whether MEUs see 14 themselves as operating under such conditions. It's 15 difficult to anticipate how the incentive powers of 16 incentive regulations would be modified in a public 17 enterprise setting. It certainly would force even the 18 management in the public setting to be more cost 19 conscious. 20 My guess is that the effect would be 21 reduced somewhat because there may be other goals, you 22 know, of providing local infrastructure or other things 23 that may interfere. 24 MR. RODGER: So can I take it from 25 your answer that really the basis of your statement is 26 the assumption that continued public ownership of these 27 assets will translate into a not-for-profit approach? 28 MR. BAUER: Could you say that again? 405 OEB Panel 1 MR. RODGER: Yes. The basis why you 2 are doubting that the effects of the efficiency 3 stimulating features of PBR, you are doubting whether 4 that can be achieved in a public ownership context 5 because the assumption is that those municipal owners, 6 if you like, will direct that their companies pursue a 7 not-for-profit type of approach. 8 MR. BAUER: What I'm saying is that 9 these mechanisms work best in a setting where 10 management has a clear profit goal in mind and if there 11 are other goals that may compete with these profit 12 goals, then the incentives plan also may not have the 13 same effect in the private ownership setting. 14 My guess would be that unless 15 management of a publicly owned firm also has a clear 16 mandate to maximize profits that the incentive effect 17 will be weaker. But that's a guess. I cannot really 18 produce a significant empirical basis to substantiate 19 that. 20 There are a few examples of publicly 21 owned utilities that are subject to regression, but so 22 far I think the experiences just cannot come to clear 23 conclusions. So my argument is really based in an 24 analysis of the incentives based on a theoretical 25 model. 26 MR. RODGER: I take it then your 27 concern in this regard would be completely alleviated 28 if it came to pass in Ontario that these vast, vast 406 OEB Panel 1 majorities, let's say over 95 per cent of these 2 incorporated MEUs owned by municipalities, if the 3 Director from the shareholder to the Board of Directors 4 to those companies was to take a commercial orientation 5 and to obtain a commercial rate of return. 6 MR. BAUER: It would be not -- I'm 7 not sure whether it would be completely alleviated. I 8 worked for a number of public enterprises when I was 9 still in Europe. I know many examples where even under 10 the direction of being commercially oriented, other 11 goals would become very important. 12 The more profit oriented management 13 is, the more you would be able to expect the beneficial 14 impacts of performance based regulation on the 15 private/public ownership setting. That's correct. 16 MR. RODGER: And certainly from that, 17 I take it, you would agree for those municipalities 18 that do direct their Board of Directors to take a very 19 commercial, if you like, maximizing profit orientation, 20 that bodes well for the PBR regimes proposed. 21 Do you agree with that? 22 MR. BAUER: I agree, but you know the 23 paragraph here is in the context of raising some 24 caution flags as to how much of an efficiency 25 improvement one can expect on a PBR. I mean, 26 incumbently, very often we tend to overestimate the 27 possible efficiency improvements. 28 I want to raise a second flag of 407 OEB Panel 1 caution. 2 Unless there is a clear measurement 3 philosophy in place for these compatible to profit 4 maximization, the PBR may work less in a public 5 ownership setting. 6 MR. RODGER: Just one other question. 7 If you turn to page 24 of your 8 submission, under paragraph 9, entitled "Miscellaneous 9 Issues", you have a statement: 10 "Thirdly, price cap plans do not 11 score well in supporting 12 longer-term infrastructure 13 expansion." 14 I am wondering if you could just 15 expand on that statement, please. 16 MR. BAUER: Yes. I should make it 17 more precise in the sense that the price cap plans work 18 best in what economists call status state scenarios. 19 In other words, we understand well future developments. 20 We can forecast those well by looking at changes in 21 input prices and looking at changes in productivity. 22 Price cap plans do not work as well if major lumpy 23 investments need to be undertaken. They are somewhat 24 out of this status state process, in other words if 25 they are a major development project. 26 We had some discussion earlier today. 27 In most cases where these issues arise, what has been 28 done is that additional components are folded into the 408 OEB Panel 1 price cap model; that you perhaps would have another, 2 an additional, adjustment factor that reflects major 3 capital investment projects when necessary. 4 The price cap plan works on an 5 assumption that today's unit costs modified for 6 inflation and productivity changes give us a good 7 forecast of future unit costs. Capital investments 8 that are compatible with this -- in other words, if a 9 utility is subject to a steady expansion process where 10 the current unit costs reflect to a certain degree also 11 such regular capital investments, perhaps through the 12 upgrades on actual system expansion, those can be well 13 treated in the price cap plan. But major lumpy 14 investment projects very often cause problems. 15 MR. RODGER: How would you respond to 16 the observation that, and in the context of our 17 currently proposed PBR Handbook, that such lumpy 18 investments may be accommodated as a Z-factor and that 19 would be the way to bring it into the process? 20 MR. BAUER: That is one way to do it, 21 yes. 22 This treatment would be analogous at 23 least to Z-factors, yes. 24 MR. RODGER: Is it also your 25 suggestion that perhaps the issue of capital expansions 26 is one that should be dealt with outside the PBR 27 process, perhaps a separate process to deal with those 28 kind of lumpy investments? 409 OEB Panel 1 MR. BAUER: I think it would give 2 absolute advantages of incentive regulation. I think 3 one should aim at integrating it into the process. 4 MR. RODGER: Thank you. Those are my 5 questions. 6 MS LEA: Thank you very much, 7 Mr. Rodger. 8 Mr. Grieve or Mr. Adamson? 9 MR. GRIEVE: Mr. Adamson has a couple 10 of questions for you. 11 I just wanted to first take you back 12 to your cv that you were describing to us. You 13 described that you were a consultant to the Board on 14 PBR, to this Board on PBR, and I just wanted you to 15 describe the nature and time of that retainer, if you 16 could, please? 17 MR. BAUER: Yes, maybe the word 18 "consultant" was a misnomer. I gave a presentation on 19 PBR to the Board. 20 --- Off record discussion 21 MS LEA: Perhaps you could give your 22 answer again? 23 MR. BAUER: I was part of the team of 24 presenters who gave a public seminar here in Toronto -- 25 was it two years ago. There were several 26 presentations, but I think to call it a consultant to 27 the Board would probably be too narrow because it was a 28 public seminar and I see many of the people here that 410 OEB Panel 1 attended the seminar. 2 MR. GRIEVE: Right. Was that with 3 respect to electricity or regulation of utilities in 4 general? 5 MR. BAUER: It was a generic seminar 6 on performance-based regulation. 7 MR. GRIEVE: Okay. I think 8 Mr. Adamson has a few questions for you. Thank you. 9 MR. ADAMSON: First, I was interested 10 in your comments on -- and we didn't have them in the 11 right order -- the assertion that nothing could be done 12 on the differentiation of the starting efficiencies of 13 utilities was probably a bit too far. I wonder if you 14 could briefly elaborate what you think might be 15 possible, given your understanding of what sort of 16 information is available and how long these things take 17 and so on. 18 MR. BAUER: Yes. Sometimes it is 19 very unsatisfying reading the background reports. 20 Apparently, the task force has looked 21 into the right issues and started to create information 22 and then very quickly came to the conclusion, but it is 23 insufficient information at this point in time. I am 24 not sure whether -- the material that I read didn't 25 really convince me that this is the case. 26 I think what ideally would be, should 27 be, achieved is some differentiation according to the 28 level of efficiencies that utilities currently have 411 OEB Panel 1 achieved. If somehow they can capture that better than 2 in the assumption that everybody is working under the 3 same price cap model, I think we would probably be 4 better off. 5 I understand though that there are 6 many trade-offs that we have to accept. Somebody who 7 came into the process at the tail end so to speak, 8 because there was no -- because the conditions were not 9 such to participate earlier on, sometimes I felt being 10 confronted with facts that I had a hard time really 11 assessing how true those were. 12 I am hopeful that some more data 13 analysis -- because the statement that no meaningful 14 differentiation can be achieved was always very quick, 15 it seems. I hope that some more meaningful analysis 16 would help us create such a differentiation. 17 It is clear from some of the data 18 that I have seen that there are patterns in the 19 population of utilities. I mean, you clearly have more 20 efficient ones and less efficient ones. I think 21 somehow we should be able to capture that based on 22 perhaps an assessment of the current productivity 23 level. 24 I think there is another way to take 25 care of this issue and I speak to it in my submission. 26 That would be rather than having a front-end safeguard, 27 by differentiating utilities according to efficiency 28 categories or groups, one goes at the tail-end 412 OEB Panel 1 safeguard in the form of an earnings sharing plan. 2 You know, I am the first one to admit 3 that earnings sharing plans have many disadvantages, 4 but I think in the context of the current issues where 5 we have a situation where there is a large number of 6 utilities, we have a fair degree of uncertainty as to 7 the quality of the data and that the potential 8 efficiency developments and earnings sharing would not 9 be such a bad thing to do because it stabilizes 10 expectations of all the stakeholders. 11 Utilities know what is going to 12 happen if they exceed -- 13 MS LEA: Dr. Bauer, if you turn that 14 far away, we can't hear in the mike and the reporter 15 can't see you and that is difficult. 16 MR. BAUER: That is my natural 17 inclination to be dramatic. Maybe I can move over 18 here. Can you hear me this way? 19 An earnings sharing plan could 20 stabilize expectations for all the stakeholders because 21 we would have a contingency map, so to speak, of what 22 would happen if the utility exceeds a target return or 23 falls below a target return. 24 I think in the context of this 25 three-year transitory plan such an approach may make a 26 lot of sense, because if you cannot correct when you 27 start the plan because you are not confident that your 28 groups, your efficiency groups, are well defined, you 413 OEB Panel 1 can get a safeguard at the end of the process when 2 looking at the outcomes and you have a sort of a 3 self-healing process. 4 So from that perspective I think it 5 was actually very, very critical seeing the asymmetric 6 implicit earnings sharing plan that is currently 7 involved, because that may lead to a number of 8 distortions that we cannot fully anticipate. You know, 9 utilities have many ways to avoid getting into the ROE 10 zone that they would be required to fully fund back 11 earnings. 12 In looking at the example that you 13 presented, I had a feeling that something is wrong in 14 the design of the combination of X factors and ROEs, 15 because it seems that the utility has a systematic bias 16 to choose a low X factor. 17 From the one example, I couldn't tell 18 if this is a generic feature that would apply to other 19 scenarios too, so I would have liked to have seen 20 perhaps more simulations of what could happen. 21 But I think it is important to see 22 those two options. I see myself as somebody who can 23 help lay out these options. 24 At the front end you can 25 differentiate into different efficiency groups, and 26 some way to cluster utilities according to their 27 current level of efficiency would be probably an 28 approximation. 414 OEB Panel 1 At the tail end you can have an 2 earnings sharing plan that is symmetric that would 3 provide a safeguard and also achieve a similar effect. 4 It is probably -- in some ways I think it would be the 5 easiest solution, given the weaknesses of the database 6 that has been pointed out several times. 7 MR. ADAMSON: On page 13 of your 8 submission and in your comments you have suggested that 9 there are two possible views of contributed capital: 10 either as an advance payment or as an investment by the 11 ratepayer, which is certainly, I think, that broad 12 differentiation I would support. 13 Then in the paragraph below you say 14 the first approach -- which I think is the kind of 15 prepayment idea -- seems more plausible. 16 What, in your view, has been -- we 17 viewed it perhaps -- not to put words in your mouth, 18 but effectively customers were prepaying for capital 19 expenditure that was done more or less loosely on their 20 behalf, sometimes in the -- generally in the form of 21 development or connection charges. But it's not quite 22 clear, I don't think, how specifically well defined 23 that it has been. 24 Other than that, what is your sense 25 of where the other capital that exists in the 26 municipally owned LDCs has come from to date? They 27 have obviously taken in money in forms of customer 28 contributions. Where has the rest come from? 415 OEB Panel 1 MR. BAUER: Sure. I think my 2 statement here was clearly influenced by the unique 3 structures as co-operatives and publicly owned 4 utilities in the past. In the end all the capital 5 comes from the ratepayers, unless there are other 6 contributions that I am not aware of through taxes or 7 other funds. Not every taxpayer in the community is 8 necessarily a ratepayer. 9 MR. ADAMSON: My limited research 10 seems to suggest that the municipalities haven't really 11 put up much or any money. 12 MR. BAUER: No, that's my research. 13 That's it. 14 MR. ADAMSON: It's kind of hard to 15 imagine a municipality volunteering to do so. 16 MR. BAUER: Yes. 17 MR. ADAMSON: So might we think of 18 those as almost like retained earnings in a business 19 where effectively the differences between rates, rates 20 set by Ontario Hydro in the past and the year-to-year 21 expenditure of the utilities has effectively produced a 22 cash stream which may or may not have been used for 23 capital expenditure? 24 MR. BAUER: In the context of a 25 publicly owned entity, like in the case of the MEUs, I 26 think the analogy of terms that come out of private 27 sector corporations like retained earnings never work 28 well. You know, sort of we are stretching those terms 416 OEB Panel 1 I think. 2 If one agrees with what many people 3 who did research and empirical work in these public 4 enterprises, that these are subject to different logic 5 of entrepreneurial behaviour, then maybe the term 6 "retained earnings" is not the right term. 7 It would be a use of funds that were 8 contributed by the owners or by the ratepayers. Now, I 9 am assuming that these are fairly congruent in most of 10 the cases. 11 Publicness very often was defined as 12 the fact that management in these entities are users of 13 whatever excess funds are available at the end of the 14 period in the interests of the owners of the company. 15 In that sense I think the term "retained earnings" is 16 also somewhat misleading, because it is fair to look at 17 public enterprises as entities that manage on behalf of 18 their owners' funds, where there are surplus funds at 19 the end of a period; that those are disposed of in the 20 interest of the owners. 21 But I would have a hard time to give 22 the analogy to retained earnings. 23 MR. ADAMSON: Retained earnings. 24 MR. BAUER: Right. 25 MR. ADAMSON: I think that the -- 26 MR. BAUER: The context here is 27 really the fact that people contribute through payments 28 to help fund the entity, and the benefit is a rate that 417 OEB Panel 1 is lower than it would be had those funds been 2 recruited at the capital market in the form of debt or 3 whatever. 4 MR. ADAMSON: I have used the 5 analogy, I guess in the first submission I prepared, 6 that in effect these were somewhat similar to 7 co-operatives in a way, not necessarily following the 8 exact accounting procedures of, say, U.S. electric 9 co-operatives but in some ways relatively similar type 10 institutions. 11 What happens when we effectively 12 demutualize a co-operative? We have created -- 13 effectively we have a set of assets which has been -- 14 whether you want to call it retained earnings or, I 15 don't know, capital expenditure funded from money not 16 spent the previous year, some less loaded term in your 17 view. Those, under the terms of the Act, seem to be 18 awarded to the municipality as a private shareholder 19 under a commercialization framework. 20 In that sense, are they not -- there 21 is effectively two sets of money here. There is some 22 that have been my retained earnings analogy, but from 23 year-to-year sort of building up of capital 24 expenditure, or there is money that has been paid by 25 what you call a prepayment mechanism. 26 I certainly agree that there have 27 been very substantial cross-subsidies probably between 28 those various sets of people. I find it very hard to 418 OEB Panel 1 believe that there have not been cross-subsidies -- and 2 I like Mr. King's technical term that it is a quagmire 3 very much. 4 But in the context of that, would you 5 not agree that the intent of the legislation certainly 6 seems to be, with commercialization and with the naming 7 of the municipalities as beneficiary shareholders, that 8 the two sets of monies, other than past 9 cross-subsidies, look roughly the same? 10 MR. BAUER: No, I do not agree. I 11 mean, "commercialization" can mean a number of things. 12 It doesn't necessarily mean a rate of return that is 13 market based, it can also mean a management attitude 14 that is cost oriented, that is customer driven. 15 Many, many of the municipalities in 16 the past I assume have had such an attitude and as is 17 reflected in the relatively positive efficiency record 18 when they are compared to other North American 19 distributors. 20 I don't want to speculate on the 21 intent of the legislature here. What I can say is that 22 from an economic perspective, we should really make 23 decisions that are forward-looking and not retroactive. 24 If one agrees that in the past public 25 ownership meant the disposal, the use of funds in the 26 interests of the owners, then I think we can leave that 27 model of the past in place. I think that 28 municipalities would probably have an opportunity to 419 OEB Panel 1 refinance those funds and then indeed pay investors a 2 dividend or a residual claim on their funds. 3 I think if your proposal is to now 4 allow them, for past contributions, to charge a 5 market-based return, what you really argue for is that 6 they be given the power to tax a captive base of 7 customers and that maybe an implicit tit-for-tat in the 8 government's thinking would give you some earnings 9 opportunity. 10 We also assign a new tax at the 11 municipal level, but I really don't want to speculate 12 on those things. 13 You know, from a regulatory 14 perspective, I think we can make more meaningful 15 decisions on a forward-looking basis. 16 Given the fact that municipalities 17 would have the option to adopt restructuring measures, 18 that really would make them more similar to a 19 privately-owned company that then would, for reasons of 20 having to compensate investors for risk and time 21 preference, have to earn a return on its capital. 22 MR. ADAMSON: I believe you agreed 23 with the necessity of rates that are effectively cost 24 reflective, including -- capital is a very substantial 25 factor input. 26 Should we, for example, throw away 27 all the capital? 28 MR. BAUER: No. I think the choices 420 OEB Panel 1 really seem to be up to the entity, not to the 2 community, whether they would like to continue running 3 those distributors in a way that reflects the spirit of 4 public ownership and gives the ratepayers the 5 advantages of not having to compensate private 6 investors for a risk and time preference. 7 It seems that this is a feasible 8 option and it could be very well in the interests of 9 the community. I mean, if I were a ratepayer in such a 10 community, I would think that this is a good way to go. 11 I would really encourage my Board, or whoever is the 12 governing body of this utility, to continue in this 13 way. 14 And the international experience -- 15 for example, the United States has many, many 16 publicly-owned utilities and we see that across long 17 time series, across vast geographic territories, those 18 public distributors tend to be lower cost than the 19 private ones. So I think it is compatible with the 20 spirit of the law. 21 That's how far I would like to go 22 into this territory, to leave this option to the 23 communities. 24 MR. ADAMSON: One observation. In 25 making assertions about the cost structure of many 26 publicly-owned utilities in the United States, one 27 needs to consider very carefully the tax advantages 28 that occur -- 421 OEB Panel 1 MR. BAUER: You know, filtering all 2 these things out. 3 MR. ADAMSON: -- to municipally-owned 4 and publicly-owned entities in the United States which 5 are often empowered to issue tax-free debt and are also 6 beneficiaries in the United States of a lot of 7 financing advantages produced through the rural utility 8 service. 9 Is it your understanding that the 10 plan laid out by Ms Kwik and Dr. Cronin and Mr. King 11 prevents a municipally-owned and controlled LDC that 12 wishes to not take a market return and effectively rely 13 on a co-operative funding model -- does their plan 14 prevent that? 15 MR. BAUER: No. 16 MR. ADAMSON: So they are free to do 17 that if they wish. 18 MR. BAUER: Correct. 19 MR. ADAMSON: If they however choose 20 to interpret a commercialization framework -- and I 21 agree that is a very broad term and it's not 22 particularly precisely defined in either the White 23 Paper or the Act -- if they choose to interpret that 24 commercialization framework an imperative to operations 25 in the sense of a normal commercial profit-maximizing 26 entity, should they be free to do that? 27 MR. BAUER: I think they are, in my 28 view, free to do that. For example, they could 422 OEB Panel 1 refinance their capital in ways that is compatible with 2 commercial practices. 3 The only thing that they cannot do 4 under the current proposal would be to charge a return 5 that is higher than what they historically have earned 6 on the contributed capital. You know, given the unique 7 situation under which these funds were generated, I 8 think that seems a meaningful policy to me. 9 Here is an option. An option would 10 be to say, okay, you let them charge a return on these 11 funds too, but they have to flow the benefits to those 12 who contributed those funds. In other words, they have 13 to go back to those people who have contributed. 14 As far as I understand it, that is 15 something that would be very difficult to solve 16 empirically because there are no track records of where 17 the funds came from. But that would be the logical 18 other alternative. 19 MR. ADAMSON: Right. 20 So you think there is a meaningful 21 distinction to be made between the prepayments on 22 capital expenditure, partially towards 23 customer-specific benefit under capital contributions, 24 and the funds generated in a spirit of public ownership 25 perhaps, year to year on the difference between rates 26 and earnings? 27 MR. BAUER: Yes. One makes sense 28 under the past setting of public ownership and the 423 OEB Panel 1 other set of concerns makes sense under a private 2 ownership setting. 3 We cannot mix those two in the way 4 you propose. I think there are really two 5 institutional set-ups, and I have outlined how the old 6 one could be made compatible with the new one by 7 refinancing, for example, capital. 8 The other alternative that I brought 9 up here has not been mentioned in the handbook and is 10 currently not at the table but could be explored as 11 well, and that is paying those who contributed in the 12 past a return on their payment. In no way can one 13 conclude from an economic point of view that such a 14 return should naturally flow to the municipality. 15 Economically that does not make sense. 16 MR. ADAMSON: No. Economically it is 17 a -- 18 MR. BAUER: That is an act of 19 taxation. That's what I said before. 20 MR. ADAMSON: Yes. Economically, it 21 could all flow to me, and I happily suggest that, from 22 the terms of the setting of efficient prices. 23 MR. BAUER: I think, you know, the 24 more meaningful regulatory strategy, as I indicated 25 before, would be to look at what can we do on a 26 forward-looking basis and not affect all the things 27 that have been in place under different institutional 28 frameworks. 424 OEB Panel 1 MR. ADAMSON: That is my final 2 question. 3 MS LEA: Thank you very much, 4 Mr. Adamson. 5 Mr. Gibbons. 6 MR. GIBBONS: Thank you. 7 Dr. Bauer, I represent Pollution 8 Probe. 9 Dr. Bauer, you are aware that one of 10 the objectives of the Ontario Energy Board Act is to 11 promote energy efficiency. 12 MR. BAUER: Yes. 13 MR. GIBBONS: The Board staff is 14 proposing a price cap form of PBR regulation, and under 15 that price cap form of PBR regulation there are two 16 fundamental ways that a municipal electric utility can 17 increase its profit: one, by increasing its sales and 18 revenues; and, two, by reducing its costs? 19 MS LEA: You have to answer in words, 20 sir, so it gets on the transcript. 21 MR. BAUER: Yes. 22 MR. GIBBONS: Thank you. 23 Similarly, under the price cap 24 regulation, if a municipal electric utility promotes 25 energy efficiency and reduces its sales and revenues, 26 it will be financially penalized also because if it 27 promotes energy efficiency it has to spend more money 28 and that would also reduce its profits and penalize it. 425 OEB Panel 1 MR. BAUER: That could well be the 2 case. 3 MR. GIBBONS: To address this 4 problem, at least on a piecemeal basis for the first 5 generation of PBR, Pollution Probe is proposing that 6 municipal electric utilities that want to promote 7 energy efficiency to reduce their customers' bills 8 could come forward to the Board on a voluntary basis 9 and ask for permission for a number of DSM incentives: 10 first, a lost revenue adjustment mechanism; second, a 11 demand-side management variance account for the costs; 12 and, thirdly, a shared savings mechanism which would 13 link the utilities' profits to their success at 14 reducing their customers' bills. 15 Does this proposal seem reasonable to 16 you? 17 MR. BAUER: Let me be more generic. 18 I think it has been established in a 19 number of regulatory proceedings in the last five 20 years, not just here but in other jurisdictions as 21 well, that price cap regimes may be in conflict with 22 conservation goals. Under very specific conditions 23 they can be compatible, for example, if an investment 24 into conservation methods would also be profit 25 increase. That could be the case. But there are 26 clearly some measures that would not fall into this 27 category. 28 What many jurisdictions have chosen 426 OEB Panel 1 to do is to establish, in addition to the price cap 2 formula, a mechanism to take care of conservation 3 issues. What you mention here, a shared savings 4 mechanism or other instruments, are fairly widely used 5 now in those jurisdictions that place importance on 6 environmental goals. 7 So from that perspective, I think if 8 there is a political bill to not lose sight of 9 conservation goals, as sometimes happens when we move 10 to a PBR regime -- you know, we lose sight of those 11 broader goals. If that really is available, that would 12 be a feasible solution. 13 MR. GIBBONS: Thank you. 14 I would now like to turn to the 15 question about a distribution utility's marginal cost 16 of delivering electricity in the short run. 17 Let's assume we have a municipal 18 electric utility that isn't subject to any system 19 capacity constraints and let's ignore line losses, for 20 the moment. 21 Under that scenario, would a 22 short-run marginal cost of delivering an extra kilowatt 23 hour of electricity to this building, or to a house, be 24 effectively zero? 25 MR. BAUER: Likely be very low. I 26 mean I have not had a chance to really, you know, 27 verify this answer empirically, so I -- logic would 28 dictate, though, it would be very, very low. 427 OEB Panel 1 MR. GIBBONS: And certainly lower 2 than the incremental distribution charges being 3 suggested in the Board staff's handbook? 4 MR. BAUER: My feeling would be, yes, 5 it would be lower, but I cannot empirically verify 6 that. 7 MR. GIBBONS: Thank you. 8 Now, turning to rate design and the 9 Board staff's rate design proposal. 10 For customers without a demand meter, 11 they are proposing a change in rate design that will 12 effectively reduce the distribution energy rate and 13 increase the fixed monthly charge for those customers. 14 Would you agree? 15 MR. BAUER: Yes. 16 MR. GIBBONS: And that change would 17 use customers' financial incentive to promote energy 18 conservation -- to reduce their consumption? 19 MR. BAUER: I think I would have to 20 think through this. 21 Not necessarily, I think. It will 22 probably depend on the options available to conserve 23 energy. So, you know, I could certainly think through 24 this in more detail; do the analysis. 25 MR. GIBBONS: Well, can we maybe 26 think through it. 27 I mean there's a lower variable rate 28 for each kilowatt hour you consume. So when you 428 OEB Panel 1 conserve, you save less, in terms of paying a lower 2 distribution rate. And your monthly fixed charge has 3 gone up. So, no matter how much you consume or don't 4 consume, that doesn't change? 5 MR. BAUER: If the proposal is 6 implemented as is in the handbook -- I mean, for the 7 moment, I thought of differentiating the fixed part 8 depending on let's say your average consumption. If 9 that would be -- if that slight modification that I had 10 proposed before would be made, then they could become 11 compatible. As you are offering it, there is a tension 12 between conservation and inter-rate design. 13 MR. GIBBONS: And, similarly, for 14 customers who have a demand meter, they are proposing a 15 change where the distribution demand charge will go 16 down and the customer charge will go up. Similarly for 17 those customers, that would create that tension and 18 reduce the financial incentive for the customer to 19 conserve energy? 20 MR. BAUER: If it's a pure per capita 21 charge, yes. 22 MR. GIBBONS: Lastly, sir, I would 23 like to turn to page 22 of your testimony. I quote 24 from, I think, the second-last sentence, where you are 25 talking about the Board staff's rate design proposals; 26 and you said: 27 "Lastly, it cannot be concluded 28 that the resulting rates will be 429 OEB Panel 1 subsidy-free." 2 I'm just wondering if you could 3 outline all your reasons for that conclusion, that the 4 new rates wouldn't be subsidy-free? 5 MR. BAUER: There are several reasons 6 for it. The two major ones are that you essentially 7 start giving the current data without really asking 8 ourselves whether the current class revenues really 9 represent the true cost structure for utilities. 10 Secondly, some of the data used to 11 apportion revenues to rate classes, to customer 12 classes, is fairly old, it seems. 13 Those two effects, for one, lead me 14 to believe that there is an uncertainty; we don't know 15 exactly whether rate are subsidy-free, at this point. 16 There are other design features in 17 the price cap plan that I had mentioned briefly before: 18 the basket provision. It is hard at this point to 19 really evaluate what the impact should be, but in the 20 longer run, unless we are careful as to how baskets can 21 be constructed and what the flexibility in those 22 baskets is, there could be in a short period of time 23 quite some significant weight shifts and fluctuations. 24 And there is an additional concern 25 that I have, as the plan unfolds: perhaps existing 26 subsidies may even be aggravated. That is one of those 27 areas that I think some more careful analysis of the 28 data would be very helpful, 430 OEB Panel 1 MR. GIBBONS: And those are the two 2 reasons why it might not be -- 3 MR. BAUER: The two main -- 4 MR. STEPHENSON: -- subsidy-free? 5 MR. BAUER: The two main reasons, 6 yes. 7 MR. GIBBONS: Thank you. Those are 8 my questions. 9 MS LEA: Thank you, Mr. Gibbons. 10 Mr. Stephenson? 11 MR. STEPHENSON: Thank you. 12 Dr. Bauer, my name is Richard 13 Stephenson. I'm counsel for the Power Workers Union. 14 At page 24 of your prefiled material, 15 you are talking about, among other things, service 16 quality indicators. 17 You make the statement there that -- 18 in addition to your other comments, you say that: 19 "It would also be desirable to 20 include an indicator of employee 21 safety into the reporting 22 requirements." 23 Can you assist me, Dr. Bauer. Why do 24 you think that is desirable? 25 MR. BAUER: It would simply reflect 26 another dimension of service quality. What you want to 27 avoid in using service quality indices and customer 28 satisfaction data, for example, is that the utility is 431 OEB Panel 1 able to passively or readily reduce the quality of the 2 service provided to save costs. 3 And in all the incentives, most of 4 the incentive designs that are known and experimented 5 with have this undesirable feature that the easiest way 6 to cut your costs is to reduce service quality. 7 One could make the point -- and many 8 jurisdictions have made the point -- that employee 9 safety is part of this aspect of the utility's 10 operation; that you want to make sure that employee 11 safety doesn't suffer under such a PBR plan. 12 MR. STEPHENSON: In the sense that 13 employee safety may be one of the factors put at risk 14 by virtue of an attempt to increase economic 15 efficiencies? 16 MR. BAUER: Well, I think what 17 happens sometimes if utilities start to work PBR scheme 18 is that the frame of mind of management changes, and of 19 employees changes as well, and very often you see that 20 good things happen; you detect safety or you detect 21 efficiency reserves that you didn't perceive prior to 22 working under the PBR plan and there are miraculous 23 improvements of efficiency that nobody anticipated to 24 that extent. 25 But there are also other reactions 26 that may not be as beneficial, and I do not want to say 27 these are fraudulent changes in management practices; 28 sometimes they are the result of wrong expectations, 432 OEB Panel 1 measures that are perhaps too drastic. There are a 2 number of cases, for example, that maintenance staffs 3 were perhaps reduced or they were used to working on 4 different shifts and therefore employee safety was 5 affected. 6 I think to avoid such potential 7 negative effects to begin with is why I put the 8 suggestion in there. 9 MR. STEPHENSON: Moving to service 10 quality more broadly, I take it that you would agree 11 with me that because there seems to be this intrinsic 12 tension in an economic incentive scheme, the service 13 quality may be put at a risk. 14 Would you agree with me that there is 15 a need to view a protection of service quality customer 16 satisfaction and these other factors as an equally 17 intrinsic important element to making an effective PBR 18 plan? Just as important as getting the economic 19 signals right? 20 MR. BAUER: In both cases, both the 21 employee safety and service quality areas, there is of 22 course an opportunity cost to maintaining a certain 23 level of service quality and employee safety. My data 24 do not allow me to identify that there is -- you know, 25 that the current level of service quality or employee 26 safety is efficient; I mean it could be too high or it 27 could be too low. 28 But assuming that there is consensus 433 OEB Panel 1 that we would like to keep the current service quality 2 level in place, then I think one should have very 3 conclusive indicators to measure the service quality, 4 and that would be an important pre-condition to this, 5 as important as, you know, the economic features of the 6 plan. 7 MR. STEPHENSON: And you are 8 concerned, on page 23 of your prefiled, regarding the 9 scope of the type of information that is to be 10 reported. I wonder if you could assist me. 11 Are there other categories of 12 information that you believe should be collected and 13 reported? Or is it simply that you believe that 14 everything that the draft proposal says should be 15 collected should also be reported? 16 MR. BAUER: Well, some of the PBR 17 plans that have been implemented in the past five or 18 six year used an additional item; that would be 19 customer satisfaction service. You know, there is of 20 course a cost of creating that kind of data. That may 21 be something to consider. 22 But I was more puzzled by the fact 23 that apparently some of the service quality indicators 24 do not have to be reported or they are not enforced, 25 and I didn't really see any logic to that; you know, 26 why that was proposed. 27 I guess what I would like to suggest 28 is to rethink that; why one couldn't put a consistent 434 OEB Panel 1 system in place so all the indicators that we deem 2 important are reported and relief measures need to be 3 undertaken in case they are not met. 4 MR. STEPHENSON: One of the concerns 5 expressed by the developers of the draft handbook was 6 about the availability of reliable and comparable 7 information in this area. They have indicated that 8 they view that as an impediment to doing more about 9 this at this point in time than has already been done. 10 They have also indicated that one of 11 the goals of first generation is to establish a base 12 line of reliable and comparable data in this area. 13 One of the proposals that my client 14 considers to be of interest is that a mechanism be put 15 in place in the PBR scheme of some kind which would 16 guarantee or would penalize or potentially penalize 17 LDCs for failure to maintain or submit the data. 18 Leaving aside whether they meet 19 standards but simply the collection and submission of 20 data, would you view the collection and submission of 21 data to be an important element towards making a PBR 22 scheme work now and in the future? 23 MR. BAUER: Yes. 24 MR. STEPHENSON: What can be done 25 about that from your perspective within the context of 26 a PBR scheme where we are supposed to be having a 27 manageable regulatory burden to ensure that that 28 important objective is in fact achieved? 435 OEB Panel 1 MR. BAUER: I mean there are 2 different basics you can achieve. I'm not sure what 3 enforcing instruments the Board has available, but I 4 assume fines, forfeitures. One could think of reducing 5 the general equities allowed for companies that fall 6 into this category. 7 I think there should be ways and 8 means to take care. 9 I think the bigger issue, rather than 10 non-reporting of quality of service data, seems to be 11 what to do in a case of a service quality standard not 12 being met and how they react in that case. 13 MR. STEPHENSON: I am going to get to 14 that in a minute. Let me just come back. At a 15 principal level at least, some kind of limitation or 16 reduction on allowable ROE is at least a theoretically 17 viable mechanism to incent compliance in terms of data 18 collection or reporting. 19 MR. BAUER: You know, if you have an 20 example in mind that you are talking about, I'm sure I 21 don't know it. It doesn't appear to me to be such a 22 major issue. I think there is an entire range of 23 feasible enforcement options that one could choose that 24 range from a limited one to a very severe one in the 25 case where there is extended non-compliance with data 26 reporting requirements. 27 I'm sure the Board has the tools in 28 place to do that. 436 OEB Panel 1 MR. STEPHENSON: One of the things 2 you mention actually in your prefile is the fact that 3 there is no specific reference to in fact what kind of 4 compliance mechanisms are to be deployed. 5 I take it you would view that as 6 being an improvement to the draft PBR plan if there was 7 something explicit in terms of the compliance 8 mechanisms that are at least available and likely to be 9 deployed. 10 MR. BAUER: I was referring to the 11 situation where a service quality target is not being 12 met, how you then translate this into management 13 action. I think it will be important to know more 14 specifically how this is to be done. You know, the 15 utilities will have a certain time period to comply or 16 there will be a financial penalty. 17 There are various ways to achieve 18 this, but that will be important to know upfront. 19 MR. STEPHENSON: In terms of the 20 first generation, do you view a form of penalty 21 mechanism to be a viable compliance mechanism? 22 MR. BAUER: The first generation PBR 23 plan could be perhaps a combination of giving it a 24 specific time period to fix a problem, combined with a 25 penalty in case, you know, relief measures have not 26 been undertaken. 27 MR. STEPHENSON: Turning to second 28 generation PBR for a moment, you explicitly indicate on 437 OEB Panel 1 page 24 of your prefile that a penalty mechanism is 2 something which should be looked towards in terms of 3 compliance on service quality. Then you reference it 4 in terms of some form of yardstick competition. 5 I wonder if you could just assist me 6 as to what you have in mind there when you make that 7 reference. 8 MR. BAUER: Well, this is not 9 referring to the situation where compliance is not 10 given. There were several approaches that one could 11 take. One is the moral persuasion. I personally 12 believe that in the complex of PBR, one should sort of 13 rely on instruments that are as compatible as possible 14 with the incentive regulations. 15 I am much more in favour of some kind 16 of a penalty that is built into the formula so that the 17 utility has clear expectations what will happen in case 18 a service quality party is not being met. 19 A number of issues arise in this 20 context, for example, how do you calibrate, let's say, 21 a one percentage point deviation of the quality of 22 service target, let's say interpenalty payments. I 23 would need some clear data to be able to give you an 24 estimate here. 25 What needs to be achieved though is 26 that the utility must not be able to be better off by 27 not complying and paying the penalty. In other words, 28 the penalty needs to be high enough to incent the 438 OEB Panel 1 utility to do the right thing, that is maintain the 2 quality of service that is desired. 3 MR. STEPHENSON: Has that exercise 4 been undertaken in other jurisdictions, to your 5 knowledge; that there is a body of analysis concerning 6 the magnitude of penalties and the mechanisms by which 7 they are imposed? 8 MR. BAUER: Yes, there has been. I 9 wouldn't be able to give you specific examples out of 10 memory, but I could write those. 11 Undertaking 12 MR. STEPHENSON: Thank you, 13 Dr. Bauer. Those are my questions. 14 MS LEA: Thank you very much, 15 Mr. Stephenson. 16 Mr. McKerlie, did you have questions? 17 All right. 18 Mr. Poch, I should call a break soon. 19 Do you want to begin or should I call it now? 20 MR. POCH: In fact, thanks to 21 Mr. Gibbons and Dr. Bauer's good answers, I have no 22 more questions. 23 MS LEA: Thank you. 24 Ms Demarco. 25 MS DEMARCO: I have about five 26 minutes with questions. 27 MS LEA: Please go ahead. Then we 28 will take a break. 439 OEB Panel 1 MS DEMARCO: Dr. Bauer, I am 2 Elizabeth Demarco. I am asking questions today 3 strictly on behalf of Lindsay Hydro and Flamborough 4 Hydro. 5 I would like to take you to page 6 of 6 your report, starting at the last full paragraph. You 7 indicate there: 8 "The electricity distribution 9 industry in Ontario raises two 10 additional issues. First, the 11 available data indicates that 12 EDCs in Ontario, at least on 13 average, were relatively 14 efficient and reliable. In an 15 international comparison, the 16 overall costs per customer are 17 at the low end and quality of 18 service indicators at the high 19 end of the spectrum." 20 You also indicate: 21 "For already highly efficient 22 firms, the range for efficiency 23 improvements under PBR is likely 24 more limited than potential 25 improvements achievable by 26 poorly managed firms." 27 I wonder if you could expand, 28 particularly on the last sentence. 440 OEB Panel 1 MR. BAUER: That's almost a trivial 2 statement, that in your status quo you are fairly 3 inefficient, that there's more room to become more 4 efficient. And I think at some later point I detail on 5 that point. 6 This conclusion necessarily works the 7 other way from the fact that the companies -- fairly 8 efficient does not mean that it cannot be able to 9 increase its efficiency in the firm. In other words, 10 from where this degree of efficiency will come and 11 necessarily conclude as to what productivity changes or 12 efficiency changes are possible. 13 You know, a good example is that you 14 see certain firms in industries that over decades can 15 be cost leaders. They are able to maintain the pole 16 position by improving their efficiency on an ongoing 17 basis. 18 The other statement here is that 19 sufficient firms have higher efficiencies. That's 20 really a very trivial statement. What the implication 21 for the PBR plan design is, the complication that it 22 raises is that there is a danger that the plan design 23 creates winners and losers by just choosing one 24 specific design. 25 MS DEMARCO: It is specifically 26 regarding that context, the winners and losing 27 regarding the initial design, that I would like to ask 28 you a few more quick questions. 441 OEB Panel 1 Specifically in the Ontario context, 2 if we are talking about a very efficient utility going 3 into this process, could they be possibly disadvantaged 4 by the initial rate structure? 5 MR. BAUER: If there are 6 opportunities to increase efficiency from where they 7 are, then they could be disadvantaged. I do not, as I 8 said before -- I am skeptical as to whether this 9 premise really is true. Only a more detailed analysis 10 would help us understand this setup. There could be. 11 MS DEMARCO: There was an indication 12 this morning that efficient utilities would in fact be 13 better off -- I will just find the wording 14 here -- their higher probability of moving to a market 15 based return and the minimization of rate shock. What 16 are your comments on that? 17 MR. BAUER: Could you be more 18 specific, because I don't recall that exact discussion 19 in the morning. 20 MS DEMARCO: I believe it was Mr. 21 Cronin in response to questions being asked by Mr. 22 Adamson, or Dr. Cronin in response to questions being 23 asked by Mr. Adamson, indicated that even though 24 utilities in the Ontario context were particularly 25 efficient, they wouldn't necessarily be disadvantaged 26 because they would more likely be able to achieve a 27 market-based rate of return and the customers would be 28 potentially faced with less of a rate shock. 442 OEB Panel 1 Is that necessarily true in your 2 opinion? 3 MR. BAUER: I think it is a very 4 plausible scenario. For one, the plan design doesn't 5 guarantee a return for utilities, so therefore fairly 6 efficient utilities are unlikely -- are more likely to 7 be able to achieve the underlying performance yardstick 8 that is driving the price cap plan. So, in retrospect, 9 I would agree. 10 Also, it is very likely if efficiency 11 research can be mobilized and has been mobilized in the 12 past there may be less need to adjust rates. 13 MS DEMARCO: Now, following up on 14 that, if rates have been adjusted, go into the PBR 15 plan, for example, if a very efficient utility has 16 adjusted rates in a downward fashion, could that 17 contribute to disadvantaging them at the outset of a 18 PBR plan? 19 MR. BAUER: Again, it is difficult 20 from that information to conclude that. It will depend 21 on all of -- 22 MS DEMARCO: Let me rephrase it. Is 23 it a distinct possibility? 24 MR. BAUER: It will depend on further 25 efficiency gains that are feasible. Only if those 26 further efficiency gains are distributed in a way that 27 the firm that you describe has a lower chance to prove 28 efficiency on a forward-looking basis would be 443 OEB Panel 1 disadvantaged. But from knowing what you are saying, I 2 cannot conclude that. 3 In other words, we cannot really 4 confuse the relative efficiency level and must not 5 confuse the efficiency level at any point in time, is 6 the potential for change on a forward-looking basis. 7 The utility you have in mind -- I assume that you 8 probably represent -- may be in a position to do very 9 well under the price cap machine despite the fact that 10 it currently has low rates and may even be reduced. 11 MS DEMARCO: Given your statement in 12 your report, though, the range of efficiency 13 improvements may in fact be limited? 14 MR. BAUER: What I am saying here is 15 that with less efficient utilities there is more room 16 to move. I don't see that it is highly efficient if 17 utilities have less room to move. I see it the other 18 way and the other way it is really trivial. 19 MS DEMARCO: So less efficient 20 utilities may have more room to find greater 21 productivity to gains and capitalize on the greater ROE 22 X-factor couplings here. 23 Is that fair? 24 MR. BAUER: That could be one of the 25 unwanted impacts, although one has to see the longer 26 range perspective. The longer range perspective, I 27 think, from the status from the perspective of the 28 province, one can say that the best thing that can 444 OEB Panel 1 happen is that the least efficient utilities become 2 more efficient fast. 3 You know, we reward them temporarily 4 with a somewhat increased return on equity. That shows 5 how these plans really sort of implicitly define 6 beneficiaries and split efficiency gains between 7 shareholders and customers. 8 One may be uncomfortable with this 9 sort of distributional impact but there are only two 10 ways out. I think one would be to come up with a 11 classification of utilities that allows us to evaluate 12 what the potential efficiency gains are in the future 13 and then group them accordingly. Those who are less 14 efficient currently would have to achieve more 15 challenging productivity gains to achieve the same 16 return on equity. 17 We have heard that this is, given the 18 current data, difficult if not impossible to do. 19 The other way would be, as I 20 indicated before, to have some earnings sharing 21 mechanism in place as sort of an ex post way to take 22 care of this. Actually, it would have been an 23 interesting variant to take care of those issues. 24 For example, in a digressive sharing 25 mechanism you would be able to filter this effect 26 somewhat, because those utilities that are less 27 efficient to begin with, have a higher range of 28 efficiencies gains that are feasible, would not 445 OEB Panel 1 proportionally gain. 2 They are some disadvantages to such 3 sharing plans. They have other undesired features. 4 But I think there are ways to take care of it at the 5 tail end of the process when you look at the outcomes. 6 MS LEA: Thank you, Ms DeMarco. 7 We will take a break now and return 8 at 3:30, please. 9 --- Upon recessing at 1515 10 --- Upon resuming at 1534 11 MS LEA: Thank you. Let's carry on. 12 Mr. Mia, you have no questions. Is 13 that correct? 14 MR. MIA: No questions. Everybody is 15 too thorough for me. 16 MS LEA: There you go. 17 Is there anyone else in the audience 18 who has questions for this witness? 19 I think Mr. Adams did. 20 Oh, yes, the gentleman at the back. 21 Please come forward to a microphone, sir. 22 MR. ADAMS: I have no questions. 23 MS LEA: Thank you, Mr. Adams, that 24 is helpful. 25 Could you just remind us of your 26 name, sir, and spell it for us? 27 MR. FAYE: Peter Faye. "F" as in 28 Frank, A-Y-E. 446 OEB Panel 1 MS LEA: Thank you. 2 MR. FAYE: Representing the Upper 3 Canada Energy Alliance. 4 MS LEA: Thank you. Please go ahead. 5 MR. FAYE: Dr. Bauer, I would like to 6 start just on a couple of general principles. 7 Would you say that one of the 8 objectives of the PBR is to have it applied fairly to 9 all utilities? 10 MR. BAUER: Yes. 11 MR. FAYE: And can we conclude then 12 that fairness would be an important criterion in 13 designing a PBR? 14 MR. BAUER: One criteria, yes. 15 MR. FAYE: Okay. Moving on to 16 contributor capital, if I understood your position, you 17 endorsed the rate handbook position? 18 MR. BAUER: Yes. 19 MR. FAYE: You are familiar with the 20 provision in the rate handbook on historic rate of 21 return for contributor capital? 22 MR. BAUER: Yes. 23 MR. FAYE: Are you familiar with the 24 range of rates of return that various utilities have 25 enjoyed over the years? 26 MR. BAUER: Broadly. I know that 27 they range from the negative ranges to various low ones 28 to more normal ones. 447 OEB Panel 1 MR. FAYE: So somewhere from a base 2 of zero to somewhere around 7 or 8 per cent? Would 3 that be fair to say? 4 MR. BAUER: Yes. 5 MR. FAYE: And you are familiar also 6 with the target rate of return of 9 3/4 depending upon 7 the productivity factor chosen? 8 MR. BAUER: Well, as far as I 9 understand it, it is just the place-holder. It will be 10 the market rate of return determined at the starting 11 date of the plan. 12 MR. FAYE: Yes, but nominally, at the 13 moment, 9 3/4 is the figure that is in people's minds. 14 MR. BAUER: Right. 15 MR. FAYE: Of course, you would admit 16 then that there is not a great difference between what 17 some utilities might have earned in the neighbourhood 18 of 8 and 9 3/4? 19 MR. BAUER: Yes. 20 MR. FAYE: Given that some utilities 21 will receive zero return on their historical 22 contributor capital and others will return almost the 23 market rate of return, do you see any conflicts with 24 that? 25 MR. BAUER: No. 26 MR. FAYE: Would you say that an 27 investor in the utility that receives the zero rate of 28 return would see themselves disadvantaged compared to 448 OEB Panel 1 the utility that receives 8 per cent? 2 MR. BAUER: I think you have to be 3 careful who you are talking about because an investor 4 in the utility would not see a return of zero per cent. 5 It is the co-owner/ratepayer who receives no return on 6 funds advanced to the utility. 7 Now, if for a forward-looking basis 8 the utility would indeed recruit investors, people who 9 dedicate money to them, give up present consumption for 10 investment in the utility, the utility would have to 11 pay the investor. 12 I think what you must not confuse is 13 sort of the historical agreement, the historical 14 contract between the owners or the ratepayers of a 15 municipally-owned utility and management of the utility 16 with the situation where we talked about investors. We 17 addressed this before. 18 I think that in the old situation you 19 cannot really talk about investors. These are not 20 investors because they do not get a return except if 21 you agree that lower rates are an indirect benefit. 22 Now, they are not investors in 23 another sense also and that is they have not 24 voluntarily paid the funds to the municipal utility 25 which would, in my view, be characteristic of an 26 investor: that you could choose where you put your 27 money in. 28 Last but not least, when you talk 449 OEB Panel 1 about fairness you also need to keep in mind that 2 fairness applies to all stakeholders. 3 I could bounce the question back: If 4 the proposal or the idea to now charge a return on past 5 contributor capital that reflects the market, is fair 6 to those who contributed those funds? And my answer 7 would be clearly "no." 8 MR. FAYE: Perhaps I could restate 9 the question. 10 I take the investor to be the owner 11 and the owner to be the municipality. We have no 12 disagreement on that score, I don't think, do we? 13 MR. BAUER: Well, in as far as the 14 municipality did not contribute to the capital that you 15 are talking about. It is hard to believe that the 16 municipality is the investor. I think, you know, we 17 have to be careful when we use analogies from 18 private-enterprise settings in public-enterprise 19 settings. 20 Mr. FAYE: Well, it's a minor point. 21 We will say "owner". Shall we say "owner"? Is that a 22 good enough term? 23 MR. BAUER: It is, yes. 24 MR. FAYE: Shall we agree that the 25 owner receives all dividends from the proceeds of the 26 corporation? 27 MR. BAUER: In private enterprise 28 settings, yes. But again, we cannot treat a public 450 OEB Panel 1 enterprise environment with the terms and principles 2 that we use in the private enterprise setting. 3 MR. FAYE: Would you agree that the 4 Act permits dividends to be paid to the owner if the 5 owner so desires? 6 MR. BAUER: Yes. 7 MR. FAYE: Okay. So given that, if 8 you were that owner, would you consider your ownership 9 to be disadvantaged if you were receiving zero per cent 10 on contributed capital and another utility was 11 receiving 8 per cent on contributed capital? 12 Would you consider yourself to be 13 disadvantaged in that case? 14 MR. BAUER: No, I would not. I think 15 there are ways that are compatible with the legislation 16 and the handbook that would allow you to change your 17 capital structure in ways that would relieve the 18 disadvantage. 19 I think what you seem to interpret as 20 a disadvantage is the ability to tax the customers or 21 the ratepayers of your municipal utility. I really 22 have to be very blunt: I think it is the goal of 23 achieving a windfall tax gain under this guise of being 24 allowed to earn a market return on investment. 25 MR. FAYE: Yes, I understand your 26 point of view on that. But you do seem to concur with 27 the rate handbook that some investors or some owners 28 will receive 8 per cent on contributed capital. You 451 OEB Panel 1 see no conflict with your other position? 2 MR. BAUER: It is because those funds 3 are different in character. Investment funds we can 4 speak of. If people give up current consumption and 5 donate funds for the use by a firm that incurs a risk 6 in running its business and to compensate those 7 investors for the risk, you pay a premium over the 8 risk-free rate of return and you pay the risk-free 9 return which is nothing else but the time preference of 10 investors to not consume the money today. 11 I think that utilities, municipals 12 who in the past have chosen to finance the operations 13 in the way that is closer to that image now have a 14 reasonable claim to charge a market return on it. That 15 others have in the past chosen to do otherwise, I think 16 it would be important to find out ways to allow these 17 utilities perhaps to refinance the operations in ways 18 that would alleviate this disadvantage that you are 19 referring to. 20 I'm not sure that this is compatible 21 with the current legal framework, but I think that it 22 would be something to really look into. 23 MR. FAYE: I think I perhaps misled 24 you. 25 I was referring, when I said 8 per 26 cent, to those utilities who have a historic return of 27 8 per cent and according to the rate handbook they will 28 receive that return on their contributed capital versus 452 OEB Panel 1 those utilities who have the historic return of 2 zero per cent and will receive zero on their 3 contributed capital. 4 What I ask you is: Given your stated 5 position, and given the fact that 8 per cent for some 6 utilities on contributed capital is very close to the 7 market based rate of return, do you see no conflict in 8 your position? 9 MR. BAUER: I think I do not, because 10 fairness in that sense would be interpreted as not to 11 change arrangements retroactively that have been in 12 place for various reasons. 13 I do assume that the utilities who 14 earned the lower historical return on contributed 15 capital did so for a specific reason. You know, they 16 are not just victims of circumstance, but there were 17 some public policy models to do so. I think it is fair 18 to acknowledge that and think of regulatory approaches 19 on a forward-looking basis. 20 Therefore, I do not see a conflict 21 between principles of fairness and leaving historical 22 arrangements in place, especially if there are chances 23 to rethink the financial structure that would allow to 24 fix these problems. 25 MR. FAYE: Thank you. 26 Those are all my questions. 27 MS LEA: Thank you very much. 28 Do Board staff or its consultants 453 OEB Panel 1 have questions? 2 MR. CRONIN: Yes, I think just one 3 area. 4 MS LEA: Please go ahead. 5 MR. CRONIN: Dr. Bauer, on page 18 of 6 your testimony, or information I guess as we are 7 calling it, you talk a bit about the issue of the 8 productivity factor, how it was derived and the normal 9 practice of putting on some kind of stretch factor. 10 A few minutes ago -- and you 11 mentioned in your testimony that the stretch factor 12 might, just to quote you: 13 "This stretch factor generally 14 ranges between one-half per cent 15 and one per cent." (As read) 16 You also mentioned a few minutes ago 17 how often it turns out that once utilities go under an 18 incentive-based regulatory scheme, I think your term 19 was "the miraculous discovery of efficiency 20 improvements". 21 MR. BAUER: Right. 22 MR. CRONIN: I wonder if you could 23 share with us your thoughts about the appropriate 24 range, because you mention at the end of this paragraph 25 that you would suggest that the default value, the 1.25 26 is possibly set too low. 27 Could you share some thoughts of that 28 with us? 454 OEB Panel 1 MR. BAUER: Yes. In the most recent 2 three years many, many proceedings have come to the 3 conclusion that a reasonable stretch factor, if you 4 want to keep the term -- in other words an 5 acknowledgement of the fact that productivity estimates 6 based on the past industry's own record tend to be 7 biased or may be biased downwards by the fact of past 8 industry conditions -- have been more closer to the 9 1 per cent range and now -- I should say have been in 10 the .5 to 1 per cent range. 11 Now, given the result that you 12 presented that the 10-year average was .87, I think I 13 recall, average productivity change, and more recently 14 it was feasible to achieve higher rates, I thought that 15 the 1.25 as a lower range was at the very low end; that 16 if one would acknowledge a somewhat higher trend in the 17 past few years and add some stretch factor that some 18 shift upwards would be justified. 19 I say this, you know, in conjunction 20 with my suggestion to establish a symmetric earnings 21 sharing framework which then would provide a safeguard 22 against mistakes of two sorts. 23 One type of mistake is that we 24 underestimate potential efficiency gains and even if 25 there is a stretch factor in place the realizable 26 efficiency gains are much higher, that is the risk that 27 consumers incur, that shareholders benefit 28 significantly and then consumers share on 455 OEB Panel 1 proportionately. 2 The other risk is, of course, the 3 down side, that we overestimate for reasons that we 4 don't fully understand because we don't have all the 5 data available on what the efficiency gains are and, 6 therefore, the utility and its owners bear a higher 7 share of costs. 8 A symmetric earnings sharing model 9 would take care of this issue. It would give very 10 clear expectations to stakeholders. 11 I mean, there are many disadvantages, 12 I think, in the long run. I would not consider such an 13 earnings sharing model as something that one would 14 envision for the second generation of PBR plan, and I 15 would be more comfortable once the database has been 16 solidified with the kind of menu of choice option that 17 has an asymmetric sharing structure, an implicit 18 asymmetric sharing structure that you propose. But 19 given the uncertainty, my recommendation would be to 20 consider at least to move to a more symmetric model. 21 The shifting the scale upwards and 22 combining it with such a more symmetric earnings 23 sharing plan goes hand in hand in my proposal. 24 MR. CRONIN: The number you 25 referenced, the .87, was the means as calculated over 26 10 years. The median was actually 1.14. As you do 27 note in the paper, the more recent five year period was 28 actually calculated at 2. 456 OEB Panel 1 Given your prior qualifications about 2 the shift upward, would you be able -- I mean, when you 3 say that floor should be shifted up several tenths of a 4 per cent, are you thinking 30 basis points? 5 MR. BAUER: Thirty to 50. 6 MR. CRONIN: Thirty to 50. So given 7 your statement prior, you would be suggesting that the 8 default value should be set at 1.55 to 1.75? 9 MR. BAUER: In conjunction with such 10 earnings, yes. 11 MR. CRONIN: Right. 12 MR. BAUER: Now, we have seen over 13 and over that there is an "endogineity" effect -- 14 MS LEA: I'm sorry, I didn't 15 understand that. 16 MR. BAUER: There is an endogenous 17 effect involved in that in most cases, with very few 18 exceptions, industry practice follows the productivity 19 target; in other words, that in cases where we set more 20 challenging productivity targets industry was able to 21 meet those more challenging productivity targets 22 despite all complaints earlier on in the process. 23 But I would emphasize again that such 24 an adjustment really would have to go hand in hand with 25 a symmetric earnings sharing structure in place that 26 would sort of provide for downward assurance for 27 utilities that they would not be caught in a vicious 28 cycle of deteriorating finances. 457 OEB Panel 1 MR. CRONIN: Accepting for the moment 2 now this issue of the symmetric sharing, would you 3 label the 1.25 a particularly challenging or onerous 4 hurdle for the utility giving the -- 5 MR. BAUER: Given the data that I 6 have seen and the empirical information that you 7 produced, no. 8 I think it is at the lower range of 9 feasible x factors. 10 MS LEA: Anything further? 11 MR. KING: Just one follow-up 12 question, Dr. Bauer. 13 Let's presume that the Board decides 14 that they wish to keep the asymmetric mechanism, would 15 you recommend an adjustment to the productivity factor 16 base in that case? 17 MR. BAUER: I had suggested to 18 perhaps engage in more simulations of other scenarios 19 than the ones that you had in the materials so far. 20 I'm not sure, but the one example 21 that you see is unique and I didn't frankly have the 22 time resources available to engage in these simulations 23 myself, but it seems that in your example a fairly 24 well-performing utility would have an incentive to 25 select a very low x factor in the menu of choices 26 because it yields the highest actual return. That may 27 just be the unique combination of numbers that you have 28 here. That may be a more generic feature of the 458 OEB Panel 1 combination of x factors and ROE targets. 2 If you keep the asymmetrical price, 3 perhaps the following modification could be considered. 4 First of all, I would consider 5 introducing one menu choice that is unlimited in its 6 ROE, in other words, to give one very challenging 7 productivity choice that has no limits in terms of the 8 profitability of the utility, then perhaps add one, 9 given the spread of productivity ranges, that is lower 10 than the one that you have in place but also has a 11 lower return on equity that is below what is considered 12 the market target return. 13 MR. CRONIN: Then, in that case, 14 you -- 15 MR. BAUER: The other range I think 16 is workable, you know. 17 MR. KING: Thank you, Dr. Bauer. 18 MS LEA: Thank you. 19 Mr. Warren, do you have anything? 20 MR. WARREN: No. Thank you. 21 MS LEA: Thank you. 22 Any further questioners? I'm 23 presuming not. 24 Okay. Thank you. 25 Dr. Bauer, thank you very much for 26 your attendance here. We really appreciate your advice 27 and particularly the initial recommendations you made 28 in your initial statement about the large issues that 459 OEB Panel 1 are confronting us. 2 Thank you very much for your help. 3 Are the gentlemen from the Upper 4 Canada Energy Alliance prepared to proceed at this 5 time? 6 --- Pause 7 MS LEA: Are there enough seats for 8 you all there or shall we ask -- okay. I wasn't sure 9 how many folk were coming. 10 --- Pause 11 MS LEA: Thank you. 12 I wonder if you could begin by 13 introducing each of yourselves, spelling your last 14 names. That would help the record. Thank you. 15 MR. FAYE: Peter Faye, F, as in 16 Frank, A-Y-E. 17 MR. FERGUSON: Paul Ferguson, 18 F-E-R-G-U-S-O-N. 19 MR. WILLS: David Wills, W-I-L-L-S. 20 MR. WOO: C.K. Woo, W-O-O. 21 MS LEA: Thank you very much. Please 22 go ahead. 23 PETER FAYE 24 PAUL FERGUSON 25 DAVID WILLS 26 C.K. WOO 27 PRESENTATION 28 MR. WILLS: I'm just going to start 460 Upper Canada Energy Alliance Panel 1 with a brief overview of our submission and then we 2 will ask some of the other members that are up here 3 with us to go into a little bit more detail in our 4 submission. 5 We are going to start by assuming 6 that other intervenors have read the submission and 7 therefore this oral presentation will simply summarize 8 our views which at that point there may be some 9 questions or clarifications. 10 When we did the submission we started 11 with an overview of the origins of PBR. I guess we 12 were struck by the fact that Ontarians have been told 13 their municipal utilities were inefficient, broken and 14 in urgent need of fixing. From our view, this was an 15 exaggeration intended to produce or elicit action from 16 the government to form a single wiresco before the 17 market opened. I believe this is an important context 18 against which the Board should relate its legislative 19 duties. 20 That is something else we looked at 21 is the -- from available data outside the province we 22 draw the conclusion that Ontario's MEUs could be 23 amongst the lowest cost of the number of the 24 comparators. In our opinion, the distribution of 25 electricity is a success story to be enhanced, not a 26 problem to be fixed. 27 I think we take the view that we have 28 yet to be proven greedy monopolists who intend to 461 Upper Canada Energy Alliance Panel 1 fleece their customers to line the pockets of the 2 shareholder who, as we have already discussed today, 3 also represents customers and ratepayers. 4 Something else I think that is 5 becoming very clear is the incredible diversity of 6 Ontario's municipal utilities, which I think in some 7 ways we can almost view that they are as unique as DNA 8 in their characteristics. We know the variant size, 9 geography, service conditions, service standards, 10 demographics, weather, growth, age of plant and 11 numerous other factors which need to be understood 12 before meaningful regulation can be applied. 13 We suggest that a one-size-fits-all 14 regulation with no transition will match only a 15 minority of MEUs given such differences. 16 I think one of the things as 17 municipal utilities that are going to be regulated by 18 the OEB is, and looking at PBR it almost looks to us as 19 though it takes the view, that whatever we are doing 20 now is correct and all that you really have to do is 21 freeze it in time and then pay for those activities 22 with ever-decreasing costs -- or ever-decreasing rates, 23 I'm sorry. Just intuitively, this has to be wrong. 24 Transition and implementation costs 25 of moving through the requirements of the new market. 26 We have to add the market-based rate of return. We 27 know that these things that are going to increase will 28 increase rates. That increase in rates is addressed by 462 Upper Canada Energy Alliance Panel 1 the handbook. 2 But in the context of increases that 3 look like, you know, anywhere from 50 to 100 per cent 4 in the distribution portion of the rates, we are 5 wondering why there is this rush to take charge of 6 efficiencies at somewhere between a half and 1 per cent 7 a year. 8 We see PBR as being more suited to a 9 period sometime after transition when accounting has 10 been standardized, when utilities can be grouped, and 11 standards and levels of service are understood and have 12 been integrated into utilities, rate bases and 13 operating practices. 14 We believe that the assumption of 15 urgency for PBR is a mistake and there is time to 16 understand its impacts without affecting market 17 opening. PBR, we are saying, is only a regulatory 18 tool. 19 We absolutely agree that regulation 20 is required, but we believe it can occur with or 21 without PBR. We are not saying that the delayed 22 implementation of PBR is the same as delayed 23 regulation. 24 On the contrary, we feel it allows 25 the Board the time and latitude to deal with many more 26 varying circumstances as they warrant using rate 27 guidelines without being overly restricted by a set of 28 rigid rules and regulations, especially in the 463 Upper Canada Energy Alliance Panel 1 transition stage which will require many individual 2 judgments and adaptations. 3 As a matter of fact, a simple 4 limitation on ROE, preferably with a cap and a floor, 5 will be all that would be needed for regulatory 6 approval. 7 Conversely, denial of rates is all 8 that is required in the first phase to protect both 9 consumer interests and shareholder interests. 10 Elsewhere in our submission, we have 11 drawn attention to something that there hasn't really 12 been a lot of discussion on but it's an example of some 13 of the transitional issues, and it's the asymmetrical 14 levels of service. 15 Now, we pick on OHFC, primarily 16 because it's one of the only examples of such detailed 17 information in the public domain, and we use an example 18 of things like PCB disposal. There's also data 19 acquisition and digital mapping. 20 What we are saying there is that if 21 these are the kind of the things that should be 22 included in the rate base, then you really have to look 23 at what utilities are doing today and consider whether 24 other utilities that aren't doing these things should 25 be encouraged to take on or assume such activities. 26 For example, another example are 27 things like meter reading schedules, where we know we 28 have variations out there between utilities that read 464 Upper Canada Energy Alliance Panel 1 monthly, bimonthly and quarterly. 2 We observed at the technical 3 conference that the data used to calculate productivity 4 may have contained some errors, and we further noted 5 that things like productivity seemed the highest for 6 MEUs with the highest customer growth. 7 Along with other intervenors, we 8 requested the opportunity to test the price and 9 productivity index data for methodology and sensitive. 10 Despite this, the Board in its wisdom has elected not 11 to make the full dataset available to intervenors for 12 analysis. 13 With the possibilities of errors in 14 methodology, we have some concerns that these factors 15 may not reflect Ontario's MEUs accurately. 16 In such a climate, we believe it 17 would be fairer and make more sense to choose a simpler 18 number, like the CPI, rather than the IPI, in the first 19 phase, and that productivity should be no higher than 20 the average for the sample utilities until more data 21 and understanding are brought to bear on the precise 22 state of Ontario's MEUs. 23 We would suggest further enhancement 24 to the productivity index would be a graduated 25 productivity index -- I don't now if that's the 26 accurate technical term for it -- but there would be a 27 mid point, and then we would see a target for more 28 efficient MEUs that would be lower than the target for 465 Upper Canada Energy Alliance Panel 1 those MEUs that were not as efficient. Although this 2 was discussed in the yardstick task force and a model, 3 I believe, is in the task force report. 4 On the subject of service quality 5 standards, we suggest that the Board move cautiously 6 from local accountability to central accountability, on 7 the basis of what kind of response the Board can offer 8 and whether you can really satisfy the concerns of 9 electricity customers similarly to the way MEUs respond 10 today. 11 We think the standards are a 12 reasonable start. But the existing standards and 13 levels of service have evolved over many years to meet 14 the expectations of Ontario's diverse communities and 15 their needs. 16 We also believe that the Board may, 17 or should, consider field staff because we believe 18 that, with the right mandate, these folks could serve 19 the Board and MEUs well. Right now -- and perhaps I 20 can be corrected if I'm wrong -- we don't see anyone at 21 the Board particularly responsible for individual MEUs. 22 If we have questions or need to discuss specific 23 circumstances, are there designated people that we can 24 call? The problems of calling different people and 25 getting different answers are well known. You 26 certainly would get continuity. 27 I'm going to take a break at this 28 point, and I'm going to ask Peter Faye to give us some 466 Upper Canada Energy Alliance Panel 1 comments on capital contributions. 2 MR. FAYE: Our position on capital 3 contributions is very straightforward. It is our 4 belief that contributed capital is not distinct from 5 any other form of capital. Our reasoning behind that 6 is that all capital in the utility has been 7 contributed, in one form or another, by the ratepayer. 8 The fact that it has been put in an 9 up-front payment rather than spread in the rates over 10 many years should not cause the distinction to be 11 drawn. The fact is that the ratepayer, and only the 12 ratepayer, has put that money forward. Therefore, we 13 have difficulty, of course, with the rate handbook 14 drawing the distinction and limiting the return on 15 contributed capital, with respect to the target rates. 16 --- Pause 17 MR. WILLS: Are you finished there, 18 Peter? 19 MR. FAYE: No. I just wanted to make 20 one comment. 21 There's been some allusion to the 22 term "windfall" by some of the presenters that have 23 preceded us, and I think this term carries an 24 unfortunate connotation. 25 "Windfall" suggests that those 26 receiving it do not deserve it. The Act makes clear 27 that the owner -- the "investor", I call him -- is 28 entitled to a rate of return, a commercial rate of 467 Upper Canada Energy Alliance Panel 1 return, and to characterize that return as a "windfall" 2 casts a pall over it that does not convey the truth. 3 So we would object to the use of that term. 4 I think that's basically our position 5 on contributed capital. 6 MR. WILLS: An observation of my own 7 was that I found the analogy in the Frontier Economics 8 paper very useful and the suggestion about enhancement 9 of the analogy, possibly if the buildings were 10 considered to be -- if the apartment buildings were 11 considered to be empty boxes and the apartments as 12 modules, then each new tenant would pay for his own 13 module and put it in the apartment building, and 14 gradually the apartment building would sell out and, 15 thereafter, benefits -- I think the landlord's name was 16 Henry, or somebody who looked after the apartment 17 buildings -- if Henry would -- 18 MR. ADAMSON: I think Henry was the 19 careless manager of the past -- 20 MR. WILLS: Oh, the careless manager. 21 MR. ADAMSON: -- who set the -- 22 MR. WILLS: Well, anyway, Henry 23 charged the same rates and would be doing all of the 24 building maintenance out of those rents, including new 25 roofs and upgrades to the air conditioning. So, 26 therefore, the benefit that the tenant gets by buying 27 his own module is that when that is put into the 28 building he then benefits from the same rates as 468 Upper Canada Energy Alliance Panel 1 everybody else. 2 I think this analogy has already been 3 drawn out today, that the tenant status would be more 4 like a municipal utility if it were considered to be a 5 co-operative or a condominium or a credit union or 6 something of that nature. And pre Bill 35, this is 7 effectively how municipal utilities operated 8 financially. 9 The last part of our submission is we 10 touch on Appendix A -- and other intervenors have also 11 referred to Appendix A in the rate handbook. And it's 12 not clear how many have applied other municipal utility 13 statistics to the unbundling and evaluated the results. 14 But Appendix A, as it stands, looks 15 to have a few problems, to say the least -- and worse, 16 we would see some significant impacts on groups of 17 customers. I think at best we can say about Appendix A 18 that it illustrates the principle of unbundling. 19 Again, it falls into the "one size fits all" trap and 20 really should be revised with enough flexibility to 21 address varying circumstances. 22 So, to conclude this portion, I am 23 going to ask Dr. Woo to make some very specific 24 comments. 25 The Upper Canada Energy Alliance is 26 concerned about the haste in which PBR regulation is 27 being introduced to Ontario's electricity sector and 28 the mistakes that could be made as a result. 469 Upper Canada Energy Alliance Panel 1 We abdicate a transition phase, with 2 a basic regulation, such as an ROE limit, to permit a 3 proper design for PBR to be developed, with adjustments 4 to accounting and standards and the levels of service 5 and improved levels of data and transparent methodology 6 for calculating indices. 7 Finally, we believe capital 8 contributions received in the past must be eligible for 9 rate of return. There is no rationale to do otherwise. 10 All assets have been paid for solely by the ratepayer 11 and the legislation does not specify two levels of 12 capital that are eligible for return. 13 So that's an overview of our general 14 submission. 15 I would like to ask Dr. Woo to give 16 us some comments on the technical supplement that was 17 included. 18 MR. WOO: In the technical 19 supplement, I provided a PBR proposal and I have also 20 prepared a six-page summary in case some of the 21 audience may not have read it. 22 In a nutshell, I advocate a price cap 23 formula that's very straightforward: It's CPI minus X 24 plus whatever Z-factors to recover costs beyond the 25 controlled MEUs. Should there be a return on equity 26 cap to balance with and return, there should also be a 27 floor. 28 If there is a sharing mechanism as 470 Upper Canada Energy Alliance Panel 1 previously just indicated by Dr. Bauer, then again the 2 sharing mechanism should be symmetric in such a way 3 that both unexpected gains and losses can be shared. 4 I have provided a few reasons why CPI 5 minus X plus the Z-factors is desirable. 6 Foremost, it is simple to implement 7 and quite easy to understand. More importantly, it 8 provides a real decline in electric rates for 9 consumers. 10 Industry standards suggest that 11 that's a fairly common form that has been used. 12 Also, the data are readily available 13 so that we can bypass a lot of the debate that we have 14 taken, so much time just an example right here on the 15 computation, data source, transparency. 16 Also, I echo Dr. Bauer's view that 17 there needs to be a clear decoupling of revenue and 18 costs to give an MEU strong incentive called cost 19 cutting. Of course, that's a concern about a potential 20 for excess return on equity. To the extent that 21 there's a cap, a net cap is determined to be accepted 22 to begin with, it is very difficult to achieve 23 excessive earnings. 24 Throughout this hearing there was an 25 issue regarding can the CPI properly track input price 26 escalation. Well, I have made some general 27 observations. Again, I have not done the empirical 28 evidence, but if one can accept the assumption that the 471 Upper Canada Energy Alliance Panel 1 price of new distribution assets is reasonably stable, 2 then the rental price of capital as defined and used by 3 the OEB will be largely driven by interest rates. 4 Inflation and interest rates basically move in tandem. 5 Labour contracts often contain the 6 cost of living adjustment clauses. There may be some 7 variation but the cost of living adjustments seem to be 8 a major concern for most labour negotiations. 9 And producer price index and CPI -- 10 again, the PPI was used as a price index for material. 11 Well, PPI and CPI I would say are highly correlated. 12 Again, I haven't done the detailed 13 analysis, but I think if the producer price index moves 14 up 1 per cent, there will also be a high likelihood the 15 CPI would also move along with it. It may not be 16 exactly 1 per cent, but they will be, you know, in the 17 same direction. 18 Now we will move on to the 19 productivity target. 20 If there's only one target, then the 21 initial value should be something that's reasonable and 22 achievable and should be computed over a fairly long 23 period of time because there are many things that can 24 affect that average productivity calculation, including 25 business cycle or one time events. 26 If a menu approach is used, well, 27 there needs to be some recognition that not all MEUs 28 are on the same starting point. An example is that for 472 Upper Canada Energy Alliance Panel 1 MEUs already taking major steps in cost cutting, the 2 room for improvement probably is smaller when all MEUs 3 are facing, let's say, the same set of technology. 4 It's the distribution. The technology is quite well 5 known. 6 In that event, well, that should be 7 like a less demanding target for MEUs have very low 8 cost and high target for high cost MEUs, because they 9 have a potential for making that improvement. 10 Then I did Z-factors. These factors 11 should be spelled out in the sense that there needs to 12 be incentives for superior service. By the same token, 13 if the performance in providing service is way below 14 whatever target you guys may come up with, then there 15 needs to be a penalty. 16 Finally, the Z-factor issue allows 17 full recovery of costs beyond the control of an MEU. 18 For instance, there are mandatory programs that may or 19 may not, such as like DSM energy efficiency. That's 20 very popular in a place like California. In fact, 21 that's just part of the Z-factor. 22 Taxes, the government imposes. There 23 is nothing we can do about it. 24 Compliance with regulatory changes 25 such as by rental protection law changes, that should 26 be, you know, a Z-factor. 27 Of course, there is the very 28 unfortunate but rare events by big storms that occurred 473 Upper Canada Energy Alliance Panel 1 last year. No matter what you do in your maintenance, 2 your line will be down and you will spend a lot of 3 money. 4 There are other aspects of our 5 proposal. One is that the design for retail tariffs is 6 equitable and efficient. Reflecting marginal costs is 7 one aspect of this. At the same time, to have a flat 8 customer rate to collect most of the imbedded costs, I 9 can see that would be inequitable in the following way. 10 For instance, you know, it's 11 considered that MEU has very little growth. Major 12 investment has, you know, just taken place so the 13 marginal capacity cost is basically zero. If that were 14 the case, using a flat customer charge would make small 15 customers pay a lot more than they have historically 16 been paying. I don't see that as equitable. 17 Another aspect is there needs to be 18 some more balanced downward pricing flexibility for 19 competitive services to prevent uneconomic bypass. Of 20 course, you know, the balanced pricing flexibility must 21 observe two constraints, one being that it should not 22 be priced below the incremental cost of that service. 23 As well, the overall rate level must also observe the 24 price cap imposed. 25 Finally, I echo my agreement along 26 with Frontier Economics' submission that the PBR scheme 27 should not be confiscatory. 28 If you take away 100 per cent 474 Upper Canada Energy Alliance Panel 1 productivy gain made in the current period, in the next 2 PBR design, well, there is a very perverse incentive 3 for one, if any rational MEU would try to withhold 4 productivity improvement so that they can win in the 5 next round. 6 For these reasons now, that is why we 7 proposed the PBR in our appendix six. 8 This concludes my presentation. 9 MR. WILLS: That's all. We are open 10 for debate. Questions I suppose. 11 MS LEA: Thank you very much 12 gentlemen. Can I ask for a show of hands who has 13 questions for this panel? 14 All right. Mr. Rodger? 15 MR. RODGER: Thank you, Ms Lea. Just 16 two questions. Perhaps, I will ask the first one of 17 Mr. Faye since you were the individual, sir, that dealt 18 with the contributed capital. 19 Has the Upper Canada Energy Alliance 20 done any kind of an assessment as to what the 21 opportunity cost to the province that would result if 22 contributed capital does not get a full rate of return? 23 And by that I mean, any estimates of lower revenue 24 flows to the province in terms of lower transfer taxes 25 or lower revenue flows to the province because of 26 reduce payments in lieu of taxes. 27 MR. FAYE: We have quantified that. 28 I believe others at this conference have given 475 Upper Canada Energy Alliance Panel 1 estimates in the hundreds of millions of dollars. I 2 think on the face that we would concur with those 3 estimates. 4 MR. RODGER: Secondly, for Dr. Woo, 5 in your proposal to use the consumer price index, how 6 would you respond to the observation that a potential 7 problem with using the CPI is that it may overestimate 8 or underestimate the real costs that utilities face, 9 and that is the benefit of using the ITI over CPI. 10 How would you respond to that? 11 MR. WOO: There are a couple of 12 issues here. For one, if the input prices are in fact 13 not affected by the MEUs, there might be some reason to 14 look at it that way. But at the same time, it is very 15 hard to determine that fact. 16 We all know that MEUs do procurement 17 and given that they are municipally owned utilities, 18 they perform competitive procurement and also act as an 19 aggressive contract negotiation. 20 Now, if you use an input price index, 21 would that make them less aggressive? I think that 22 that point was pointed out also in Dr. Bauer's 23 submission. That is one aspect of this. 24 Second, I think there is a more 25 practical issue. We don't know how to compare an IPI 26 in the ideal sense, given the data limitation, time 27 constraints and all that. So then we must fall back to 28 our second-best solution. The second-best solution is 476 Upper Canada Energy Alliance Panel 1 to follow the industry standard, a fairly simple way of 2 doing things, and it has been used by a number of 3 jurisdictions and even had someone adopt it quite 4 recently. 5 If the CPI has so many defects, then 6 it raises the question: Why is IPI not the industry 7 standard? 8 I even go back one step further to 9 say that while under certain assumptions -- those that 10 I provided in my slides to say that if CPI is such a 11 bad proxy for IPI, not only through IPI, then I provide 12 some reason for that. 13 If interest rate is a significant 14 driver of the rental price -- that is one of the input 15 price that I use in the handbook. If the interest rate 16 is in fact the major driver, inflation and interest 17 rate move together quite well. 18 Second is wage rate. MEUs face union 19 and labour contracts. So the wage negotiation on the 20 price, I am quite sure there is a cost of living index, 21 or a cost of living adjustment that is based on some 22 measurement of CPI, or equivalent or some form of 23 inflation measurement. 24 Then the last price index that the 25 handbook used is the producer price index. I submit to 26 you, they tend to move together. Whether they move 27 together in lockstep, that I cannot testify to at this 28 moment. But that one is subjected to applicable 477 Upper Canada Energy Alliance Panel 1 checks. 2 MR. RODGER: You mentioned in your 3 response that you thought that at least one 4 jurisdiction very recently adopted a CPI in this 5 context. Can you tell us which jurisdiction that was 6 and was it with respect to the issues that we are 7 dealing with here in terms of a PBR regime for 8 electricity distributors? 9 MR. WOO: Okay. The most recent one 10 that I can find now, that is in my submittal, at page 11 19, in Table 2. Socal Edison was given the PBR cap 12 based on CPI. Socal Edison at that time was an 13 integrated utility. 14 MR. RODGER: Thank you very much sir. 15 Those are my questions, Ms Lea. 16 MS LEA: Thank you very much, 17 Mr. Rodger. 18 I think the next person over was Jack 19 Gibbons. 20 Mr. Adams, you have nothing at 21 present. Thank you. 22 Mr. Gibbons. 23 MR. GIBBONS: Thank you. I have a 24 couple of questions for Mr. Ferguson. 25 As you know, the Board staff's 26 proposal for price cap regulation will financially 27 penalize a municipal utility if it promotes energy 28 efficiency, and Pollution Probe has come forward with a 478 Upper Canada Energy Alliance Panel 1 proposal to partially correct this problem, at least in 2 the interim first generation of DSM. And that is to 3 allow any municipal electric utility that wants to 4 promote energy efficiency and reduce its customers' 5 bills to come forward on a voluntary basis and apply to 6 the board for PBR mechanisms that would reward it for 7 reducing customers' bills -- PBR mechanisms similar to 8 those that are available for Ontario's gas utilities. 9 In particular, we are suggesting a 10 municipal electric utility could apply for a lost 11 revenue adjustment, a demand side management variance 12 account and a shared savings mechanism. I am just 13 wondering if you can comment whether you think this is 14 a reasonable proposal. 15 MR. FERGUSON: I knew you would ask 16 me. 17 --- Laughter 18 MR. FERGUSON: In terms of what we 19 have looked at, and I think what Dr. Woo indicated is 20 that maybe DSM and energy efficiency from a pure wires 21 company or an LDC ultimately may end up being a 22 Z-factor where it is mandated either by a government or 23 a regulatory authority. 24 In the period of transitiona, I would 25 tend to agree that if there are DSM projects that have 26 been implemented already, which I understand is in 27 progress in Toronto Hydro and such, that those programs 28 should be given the benefit of carrying on even through 479 Upper Canada Energy Alliance Panel 1 the LDC while we go through the transition period. 2 I guess my answer is yes, I would 3 agree with you. I don't know what all the details of 4 it are, but my fear would be that if there are viable 5 DSM or energy efficient programs implemented or being 6 implemented right now, and because of a preliminary 7 PBR, they would be disincentet, I don't think that 8 would be right. I think the incentives should at least 9 carry on through the transition period or through the 10 initial PBR period. 11 MR. GIBBONS: Thank you. Also, do 12 you believe that medium sized electric utilities and 13 small electric utilities have the potential to cost 14 effectively deliver DSM? 15 MR. FERGUSON: Yes. Without going 16 any further, yes, I do. 17 MR. GIBBONS: Thank you. Those are 18 my questions. 19 MS LEA: Thank you, Mr. Gibbons. 20 Mr. Stephenson, did you have 21 anything? 22 MR. STEPHENSON: No questions, thank 23 you. 24 MS LEA: Thank you. 25 Mr. McKerlie? 26 MR. McKERLIE: Just a quick one with 27 respect to the CPI. I think you may have touched on it 28 but I am not sure I fully understood the answer. 480 Upper Canada Energy Alliance Panel 1 But as I understand the concept of 2 CPI, it gives you something that is simple to 3 implement, easy to understand and I would expect 4 forecastable and tracked benefits associated with the 5 CPI. 6 In that the consultants have spent a 7 fair amount of time in their work to date explaining 8 why CPI wasn't appropriate relative to an IPI index, 9 have you done any work with respect to other factors 10 that may be available in the market, either forecasted 11 or tracked, that could be utilised to give you the same 12 sort of simple to implement and easy to understand 13 characteristics such as some form of wholesale product 14 price index? 15 You referenced producer price index 16 and I am not sure whether you had evaluated that or 17 not. 18 DR. WOO: Well, I referenced that 19 because that was an issue raised by the OEB consultants 20 on the correlation of the CPI reflecting costs. So 21 let's leave it at that. I will answer that piece. 22 So like in terms of answering your 23 question regarding is there any other proxies 24 available, well, typically the most prevalent being 25 used are two: either the CPI or the gross domestic 26 product implicit price index. That is also being 27 published regularly, I believe by Statistics Canada. 28 So either one. Again, we are not 481 Upper Canada Energy Alliance Panel 1 talking about a perfect ideal solution as contemplated 2 in a perfect information competitive world. What we 3 are here to do is come up with a practical solution to 4 induce productivity gains and cost cutting. 5 To the extent that the formulas, the 6 measurements may not be perfect, then so long as there 7 is some form of sharing mechanism, those concerns can 8 be reduced, as suggested by Dr. Bauer. 9 So I submit to you, if you were to 10 choose a simple proxy I would propose a CPI or perhaps 11 a gross domestic product implicit price index will be 12 fine, something that is ready, observable, not computed 13 by any party involved in the hearing. 14 MR. McKERLIE: I think I'm with you 15 on your concept. 16 I guess specifically though, the 17 GDPPI, do you feel has any benefit over the CPI? Again 18 I'm recognizing that the work done to date has 19 specifically compared the IPI to the CPI and suggested 20 CPI shortcomings. Does the GDPPI suggest any advantage 21 to the CPI that would address some of those issues that 22 have been identified so far? 23 DR. WOO: I have not even -- no -- 24 thought on this one. 25 MR. McKERLIE: Thank you. 26 MS LEA: Thank you, Mr. McKerlie. 27 Mr. Poch. 28 MR. POCH: Yes. For Dr. Woo. 482 Upper Canada Energy Alliance Panel 1 Dr. Woo, you are, I guess, another 2 doctorate in economics here today, and you have sat 3 through the last couple of days and you are obviously 4 quite familiar with the proposal. 5 Could you comment briefly on your 6 views of whether the Board staff proposal would incent 7 or disincent a utility to engage in energy conservation 8 activities? 9 DR. WOO: I believe you need to be a 10 little bit more specific on what aspect of their 11 proposal. 12 MR. POCH: The price cap aspect. 13 DR. WOO: If the price cap is 14 designed to be above marginal costs, that it so 15 happened it turned out to be above marginal costs, then 16 the incentive to adopt DSM obviously is low, because 17 for every kilowatt hour sale there would be a mark up 18 of margin. For this reason other jurisdictions also 19 propose incentive schemes for DSM programs. 20 MR. POCH: Thank you. 21 MS LEA: Thank you, Mr. Poch. 22 Ms Demarco. 23 MS DEMARCO: I'm going to pass. 24 Thank you. 25 MS LEA: Thank you. 26 Mr. Mia? 27 MR. MIA: No questions. 28 MS LEA: Dr. Cronin? 483 Upper Canada Energy Alliance Panel 1 MR. CRONIN: Yes, a few questions, 2 please. 3 MS LEA: Go ahead. 4 MR. CRONIN: These would be addressed 5 to Dr. Woo. 6 As I understand it, in your statement 7 I think you said twice that you actually have not done 8 any empirical work looking at these different price 9 indices. I believe those were your words, you actually 10 had done no empirical work comparing -- 11 DR. WOO: No. 12 MR. CRONIN: So you have not done any 13 empirical work? 14 DR. WOO: I can also respond to this 15 question at least from my reading of financial 16 literature on the expectation that interest rate and 17 inflation move together, assuming the financial market 18 is efficient. 19 So like the first one I feel 20 comfortable with. 21 The second one, I think probably some 22 of the MEU managers here can attest to that whether 23 their labour contract contains -- 24 MR. CRONIN: I was specifically 25 referencing your first statement. I want to stay with 26 the CPI and -- 27 DR. WOO: Sure. 28 MR. CRONIN: -- and the interest 484 Upper Canada Energy Alliance Panel 1 rate. 2 Now, we have ascertained that you 3 haven't done any empirical work on this issue, but 4 would you agree that the cost of capital is a 5 significant portion of an MEU's total cost? 6 DR. WOO: Yes. 7 MR. CRONIN: Okay. We had actually 8 calculated it at about 45 per cent. Would that seem 9 reasonable to you? 10 DR. WOO: It seems to be reasonable. 11 MR. CRONIN: All right. 12 You had also made the statement, I 13 think three times now, that the CPI and the interest 14 rate actually are very highly correlated, would move in 15 the same direction. 16 I would just point you to the staff 17 report on productivity, pages 18 and 19, in which we 18 actually provide the information on the CPI and on the 19 Canadian Long Bond rate. 20 For those of you who don't have that 21 data, what it basically displays is the fact that the 22 CPI rises each year from 1988 to 1997, increasing over 23 that period by 27 per cent. It also demonstrates that 24 the Canadian Long Bond rate fell 35 per cent and that 25 that decline was almost monotonic. So that, on the one 26 hand, between 1998 to 1997 we have the CPI rising 27 27 per cent and the interest rate falling 35 per cent. 28 MS DEMARCO: I'm sorry, Jennifer. 485 Upper Canada Energy Alliance Panel 1 Can you repeat the reference, please? 2 MS LEA: That is what I was going to 3 get. 4 Dr. Cronin, what are you referring 5 to? 6 MR. CRONIN: I'm referring to the 7 "Productivity and Price Performance for Electric 8 Distributors in Ontario. 9 MS LEA: Okay. That is the title of 10 the document? 11 MR. CRONIN: Yes. 12 MS LEA: It was one of the documents 13 that was on the Web site? 14 MR. CRONIN: Yes. 15 MS LEA: Okay, that's fine. 16 Thank you. 17 DR. WOO: Can you tell me which page? 18 MR. CRONIN: Yes, it's pages 18 and 19 19. 20 MS LEA: Dr. Woo, do you have this 21 available? 22 --- Pause 23 MR. WOO: My document says it is only 24 page 11. That appendix where you did the work -- 25 MR. CRONIN: I'm not going to ask any 26 further questions on this. 27 I would just ask that if in fact one 28 were to look up the data and, subject to check, assume 486 Upper Canada Energy Alliance Panel 1 that we have reasonably captured the movement in long 2 term interest rates which had gone in the early 1980s 3 from the high teens or 20 per cent down to the current 4 6 or 7 per cent, and we captured half of that period on 5 page 18 -- or page 19, would you still maintain that 6 the CPI and the interest rate moved in the same 7 direction? 8 MR. WOO: I would have to do my 9 independent checking. 10 MR. CRONIN: You will check on that? 11 MR. WOO: Sure. 12 MR. CRONIN: Okay. But I would 13 reference everyone to the staff report which 14 demonstrates -- 15 MS LEA: Thank you, Dr. Cronin. 16 Actually, if you have questions for the witness -- 17 MR. CRONIN: I'm sorry. Okay. 18 A further question has to do with the 19 statement that the CPI minus X provides a real decline 20 in rates. Are you suggesting that at least over 21 history that the real decline in electric rates 22 produced by the CPI minus X would have been higher than 23 the IPI minus X? 24 Would not in fact -- 25 MS LEA: Can you let the witness 26 answer the question, please. 27 DR. WOO: All I'm saying is that 28 going forward there is an electric rate measured in 487 Upper Canada Energy Alliance Panel 1 nominal dollars. When you deflate that by the CPI, to 2 the extent that there is inflation rather than, let's 3 say, deflation, then the real rate that the consumers 4 are paying is coming down. 5 MR. CRONIN: Over history. 6 DR. WOO: No, I didn't say over 7 history. 8 MR. CRONIN: Over history -- 9 DR. WOO: No, I did not say anything 10 about history. I just said going forward if you use 11 this formula then you will come in with a declining 12 real rate, electric rate. 13 MR. CRONIN: Which formula over 14 industry, the CPI minus X or the IPI minus X, would 15 have produced the larger decline? 16 MR. WOO: I didn't look at the 17 history, but going forward you calculate one price cap, 18 adjust it this way, you will produce the result that 19 the real electric late level will come down -- "real" 20 being in real dollar terms. 21 I don't know why two economists 22 cannot -- they say, "Well, that's normal." 23 --- Laughter 24 MR. WOO: Two economists cannot even, 25 you know, agree on the definition of a simple term. 26 MR. CRONIN: I'm simply asking over 27 history. 28 MS LEA: I think you have had the 488 Upper Canada Energy Alliance Panel 1 witness' answer that he didn't look at the history of 2 the -- 3 MR. WOO: You asked the question. I 4 answered you. You are not happy with the answer. That 5 is all I can do. 6 MR. CRONIN: Okay. Two more 7 questions. 8 In three of submissions to this 9 proceeding -- that by Dr. Bauer, that by Dr. Adamson 10 and that by the staff of the OEB -- there is a 11 discussion about how one can equate a CPI or a 12 GDPPI-based formula with that based on an IPI approach. 13 Are you familiar with those adjustments to the CPI 14 which would theoretically equate that approach to an 15 input index-based approach? 16 MR. WOO: I did not carry out any 17 analysis on that. 18 MR. CRONIN: Thank you. 19 MS LEA: Thank you, Dr. Cronin. 20 Are you going to venture in, 21 Mr. King? 22 MR. KING: Yes, just for half a 23 second. 24 Dr. Woo, would you believe that 25 perhaps not all utilities are in similar circumstances? 26 MR. WOO: Yes. 27 MR. KING: And that some may be high 28 cost because of the circumstances that they are in and 489 Upper Canada Energy Alliance Panel 1 some may be low cost because of the circumstance they 2 are in? 3 MR. WOO: Yes. 4 MR. KING: Okay. 5 So if we were to look at your 6 suggestion that if we have a menu approach which would 7 have a low target for productivity factor, for low-cost 8 MEUs, as I understand it, and a high target for 9 high-cost utilities, would you wish to make any 10 adjustments in that to reflect the circumstances that 11 one finds one's self in? 12 MR. WOO: Yes, comparing two 13 utilities that are otherwise identical except in their 14 course. 15 Like, for example, you can have a 16 similar customer mix and they are in similar geographic 17 locations and yet one utility has quite a bit of costs 18 above the other one, then it shows that simply they are 19 in similar circumstances aside from maybe like 20 management style or like their aggressiveness in 21 contracts and negotiations in terms of the bidding, you 22 know, for services. So in those circumstances, I think 23 there needs to be a difference in the threshold. 24 MR. KING: So just to paraphrase, I 25 think you are suggesting that if you have some 26 circumstances that lead some to be naturally more 27 expensive than others, there would need to be some 28 adjustment in the mechanism? 490 Upper Canada Energy Alliance Panel 1 MR. WOO: Yes. Like, for instance, I 2 don't try to mean that let's say for a utility serving 3 mainly an urban area that requires underground lines 4 vis-a-vis let's say a suburban area MEU's overhead 5 lines. Obviously, there is a significant difference in 6 cost there. 7 By the same token, in two rural MEU's 8 service territories if one has to string out a line to 9 a really far and very low customer density, obviously 10 the one with low customer density would have a high 11 cost, and those need to be recognized. 12 So in recognition of this, therefore 13 there needs to be a more careful look at some of the 14 cost structure. Namely, you need to take a look at the 15 external factors such as, like, customer mix, size, 16 density, and those are the very significant drivers. 17 MR. KING: Okay. Thank you, Dr. Woo. 18 MS KWIK: My question I guess is for 19 Mr. Wills. 20 In your submission, recent 21 submission, you suggested that -- with regard to rate 22 unbundling you suggest that the COP could be derived 23 using the proposed methodology but it should be backed 24 out of the existing block structure which would remain 25 in place until after market opening and a proper cost 26 allocation process. 27 Could you briefly describe this 28 process as well as the resulting residential and 491 Upper Canada Energy Alliance Panel 1 general service distribution rate structures? 2 MR. WILLS: This is a notion as 3 opposed to an established method. But I think the idea 4 is if you back it out of the existing rate structure it 5 would somehow follow the existing blocks. So the 6 existing block structure would remain until market 7 opening but you would have backed out the cost of 8 power. 9 It had very little impact. I did 10 some testing with it and I found that it had very 11 little impact on residential. The main impact was when 12 you started to get into general service. 13 MS KWIK: So your distribution rate 14 structure, then, would stay in the same form as your 15 bundled rate structures right now. 16 MR. WILLS: That was the idea. 17 MS KWIK: Thank you. 18 MS LEA: Thank you very much. 19 Any other questioners for this panel? 20 Mr. White. You have to use a 21 microphone, sir. 22 MR. WHITE: Thank you. 23 Mr. Faye, on contributed capital 24 there were generally two statutory drivers for 25 contributed capital within Ontario, one being the 26 Planning Act, the other being the Development Charges 27 Act. Have you any sense of the proportion of 28 contributed capital which would have been produced from 492 Upper Canada Energy Alliance Panel 1 either of those alternatives? 2 MR. FAYE: I'm familiar with the 3 Development Charges Act. I'm not certain I follow your 4 argument that the Planning Act is acting as a driver 5 for contributed capital. 6 MR. WHITE: Historically the Planning 7 Act predates the Development Charges Act substantially 8 and the Planning Act dealt with site-specific 9 contributed capital issues. 10 The Development Charges Act, which 11 came along later on, was in some ways substantially 12 different from the Planning Act, which tended to be 13 taken directly by the municipal electric utility, where 14 the development charges were part of a process where 15 the municipality passed a bylaw which put the 16 development charges in place. 17 What I'm trying to get a handle on -- 18 and any of the panel members who want to talk to it 19 please jump in -- is the proportion that would have 20 been driven by the two components. 21 MR. FAYE: I follow your question 22 now. Thank you. 23 I can speak for Markham Hydro. 24 Whether we are representative of all urban utilities, I 25 wouldn't want to make that assumption. 26 But in Markham Hydro's case, 27 development charges account for a much lesser component 28 of our contributed capital than would contributed 493 Upper Canada Energy Alliance Panel 1 capital flowing from development. I would say that 2 that ratio would be five to one. 3 An interesting side light, and 4 perhaps Ms Kwik can correct me if I'm wrong, our 5 reading of the rate handbook allows the capital that 6 comes by way of DCA to be included in the rate base and 7 it is not considered as contributed for the purposes of 8 making rates. 9 Am I right or wrong in that? 10 MS KWIK: I don't know that I 11 understand your question. Would you mind repeating it? 12 MR. FAYE: I think Mr. White is 13 referring to two sources of what we have categorized as 14 contributed. One is that capital that is forthcoming 15 from a homeowner when he buys a new home and we have 16 charged him to put the wires in the ground and that 17 capital that is levied at the building permit stage on 18 our behalf by the town and that is called development 19 charges. Development charges we thought were not 20 considered contributed for the purposes of MBBR whereas 21 the other form of contributed capital was. 22 MS KWIK: Actually, we assumed that 23 you had included the developmental charges in your 24 contributed capital in your accounts so that it would 25 show up in that account under contributed capital. So 26 it is included in that. 27 MR. FAYE: So you are saying that I 28 have misread it? 494 Upper Canada Energy Alliance Panel 1 MS KWIK: Yes, it's included. 2 MR. FAYE: Okay. Thank you. 3 Sorry for the aside, Roger. Go 4 ahead. 5 MR. WHITE: No problem. 6 I have one more question and, again, 7 maybe Dr. Woo would be the one who might initially want 8 to respond to it, but I would also be interested in 9 whatever comments the rest of the panel might have. 10 What it has to do with is in comments 11 and information put forward this morning by the Board's 12 consultant, they suggested that their preference was a 13 sliding scale customer charge dependant in some way -- 14 and if I characterize it wrong, please jump in because 15 we are trying to get the information out here -- a 16 sliding scale customer charge which might be different 17 depending upon size and possibly even in some way use 18 levels. I don't know whether they went so far as, in 19 their thinking about it, to think about load factor or 20 other related matters. 21 Would you feel more comfortable with 22 that kind of a strategy, for a customer charge to be 23 applied in an unbundled regime? 24 MR. WOO: First of all, I think we 25 have to be careful about using the word "customer 26 charge". "Customer charge" gives you a notion that is 27 flowed to the customer, that give you the notion of 28 flat charge. I would rather say that it is, in many 495 Upper Canada Energy Alliance Panel 1 jurisdictions -- and even in the FERC rule -- it is now 2 recorded just an access charge based on size. Under 3 the Federal Energy Regulatory Commission order fixed 4 costs that have been used to instal the existing 5 network should be pro rata share among all users. That 6 give rise to a size measurement now. 7 Then, the question here is: Should 8 we measure customer using a historic consumption level 9 or a historic maximum demand level? 10 That's very much a data issue. 11 But the fact is a lot of the 12 distribution assets were put in place, driven by low 13 growth. So it is the historic consumption or historic, 14 you know, demand growth that cause historic 15 expenditures, so that pro rata treatment conveys 16 fairness. 17 MR. WHITE: That's all. Thank you. 18 MS LEA: Thank you, Mr. White. 19 I think that's it. 20 Gentlemen, thank you very much for 21 attending and, also, for waiting until the end of the 22 day to make your presentations. 23 I have one request of you. I'm going 24 to assign exhibit numbers to the handouts that you have 25 given us. 26 Do you have a couple of clean copies 27 you could leave with us? 28 Thanks. 496 1 While we are producing those, I 2 should just indicate to parties that the package that 3 Board staff referred to in its opening statement, we 4 will give that Exhibit A -- and I don't believe there's 5 been anything further filed, so we will give the 6 package submitted by the Upper Canada Energy Alliance 7 Exhibit B, please. 8 EXHIBIT A: Package referred to 9 by Board staff in its opening 10 statement 11 EXHIBIT B: Package submitted by 12 Upper Canada Energy Alliance 13 MS LEA: If there's anything I have 14 forgotten, please let me know. 15 MR. MIA: Could we have copies of 16 that? I didn't get a copy of that. I think you have 17 run out. 18 MS LEA: Certainly. I'm going to be 19 getting some clean copies. We will get them to you by 20 tomorrow, perhaps. 21 Now, we have agreed that we will sit 22 until six tonight in order to enable those people who 23 have questions for Mr. King to put them to him because 24 this is his last day of availability. So we are going 25 to do that. 26 I'm going to take a break before we 27 do that. And such diehards as wish to return for this, 28 could we be back, please, in 10 minutes. 497 1 --- Upon recessing at 1655 2 --- Upon resuming at 1707 3 MS LEA: All right. Now that we have 4 separated the men from the boys, or the fools from the 5 others -- I don't know -- we will just start again, 6 please. 7 The OEB's staff and consultants are 8 again open for questions. 9 Who is beginning with questions? Can 10 I ask -- I don't know whether, Mr. Harper, you were 11 going to begin or Mr. White was going to continue. 12 MR. WHITE: I'm happy to give 13 Mr. Harper the first 20 minutes and see where he is, at 14 that point. Because I understand he has some time 15 constraints that I don't have. 16 MS LEA: You have time constraints, 17 Mr. Harper? Please go ahead. 18 Now, Mr. Harper, we have had your 19 appearance. H-A-R-P-E-R, I believe, is your last name? 20 Thanks. 21 RESUMED: JUDY KWIK 22 RESUMED: FRANK CRONIN 23 RESUMED: MIKE KING 24 MR. HARPER: I would like to start 25 off by following up on some of the comments I heard 26 during the day and a half. 27 During the discussion that you had 28 with Mr. Rodger from Toronto Hydro, you were talking 498 OEB Panel 1 about cost allocation methodologies. 2 Would you agree that doing a cost 3 allocation is something that requires a fair amount of 4 data; you have to establish the methodology; and it's 5 not something that can be done overnight? 6 MR. KING: Yes. 7 MR. HARPER: It's in that context 8 that I heard, and I think it was Ms Kwik say that when 9 the final handbook came out there would be guidelines 10 in the handbook as to how utilities who wanted to do 11 their own cost of service study should go about doing 12 it. 13 To be quite honest, that concerned me 14 because people who want to do cost of service studies 15 are probably starting now to do them in time to meet 16 next May and I just wanted to get a clarification if 17 that was correct; and, if there were guidelines, like, 18 how detailed were they going to be? 19 MS KWIK: Actually, I know that I did 20 refer to -- there is some initiative being taken at the 21 Board and Board staff have worked together with the MEA 22 on studies that -- a model, I think, that they were 23 trying to develop. 24 Other than that, there isn't much, 25 really, that -- 26 MR. HARPER: Maybe the short question 27 is: You don't see this model, as it's currently being 28 developed, being prescriptive for the first round of 499 OEB Panel 1 cost allocation studies? 2 MS KWIK: No. 3 MR. HARPER: Thank you. 4 MR. KING: Mr. Harper, I think it is 5 important to clarify what we mean by "first round". 6 It may very well may be that there 7 are guidelines that are issued for the cost allocation 8 studies that are required to be done by the utilities, 9 over the term of the first generation of PBR. 10 MR. HARPER: That's fair. I was 11 talking about, I guess, maybe even pre first round, in 12 terms of the option given to those utilities that 13 didn't want to follow the Appendix A and do the rate 14 unbundling and try and do a cost of service from the 15 start -- 16 MR. KING: Certainly. 17 MR. HARPER: -- for their filing for 18 next year. Sort of "round one: zero minus one", 19 maybe, is what I should have said. 20 I also want to follow up on the 21 conversation you had with Mr. Rodger around rate 22 volatility. 23 There was a suggestion there that 24 distributing companies didn't have to go all the way up 25 to the price cap; they could implement something less 26 than the price cap. I want to understand how that 27 would apply in a subsequent year. 28 Let's say, in the first year of the 500 OEB Panel 1 plan, you can increase your rates by 1 per cent -- how 2 the formula works out -- but you chose to go to zero, 3 instead. Could you bank that difference of 1 per cent 4 and apply it next year? Or would you be stuck -- the 5 next year's increase would be all you could apply in a 6 subsequent year? 7 MR. KING: You can bank it. 8 MR. HARPER: Thank you. 9 I hope the rest of them go quite this 10 quickly. 11 Also, I wanted to clarify the overall 12 applicability of the handbook. There's been a lot of 13 discussion here and a lot of reference to MEUs and I 14 just want to make sure. 15 My understanding is that this 16 handbook would apply to anybody who is licensed by the 17 Board to distribute electricity in the Province of 18 Ontario and, therefore, requires a rate order from the 19 Board? 20 MS KWIK: That's right. 21 MR. HARPER: Thank you. 22 I would like to turn to Section 23 4.4.1 -- that's discussing the Z-factors -- in your 24 report. I think it's page 4-7. 25 In there, under "Materiality", you 26 make the comment that: 27 "Expense will be considered 28 material if it involves .0025 501 OEB Panel 1 per cent of the utility's net 2 assets." (As read) 3 You then go on to say: 4 "The definition of `materiality' 5 will differ depending upon --" 6 And I assume you meant the size of the utility. 7 Now, is this last sentence meant to 8 qualify that the .0025 could change, depending upon the 9 size of the utility, or that when you apply that 10 per cent to the asset base, obviously, the number 11 changes by size of utility? 12 I would just like to clarify this for 13 me, please. 14 MR. KING: I think the intent was 15 when you apply it to the size of the asset base it 16 changes. 17 MR. HARPER: Fine, thank you. 18 I just wanted to make sure we weren't 19 sort of introducing a further modifier in the rules 20 here. 21 MR. KING: Right. 22 MR. HARPER: I would then like to 23 look, briefly, at rate flexibility. I think I have the 24 answer to my question, but when I was reading Section 25 4.5.1 -- that's on page 4-9; we looked at the first 26 paragraph -- it made reference to "pricing pressures 27 and particular submarkets". I was kind of intrigued by 28 what was meant by the term "submarkets". 502 OEB Panel 1 Now, during the discussion over the 2 last day and a half I think I understood it to mean 3 submarkets as limited strictly to the broad customer 4 classes, residential, general service and street 5 lighting? 6 MR. KING: I don't think that is 7 necessarily the case, Mr. Harper. Certainly those 8 could be elements of submarkets. 9 Other elements of submarkets might be 10 billing and revenue collection services, as opposed to 11 simply wire business operators. 12 MR. HARPER: No, but in that case you 13 would be looking at submarkets from a functionality of 14 the MEU as opposed to, let's say, submarkets, you 15 know -- to be honest, if I wanted to take my 16 residential class and break it into large residential 17 customers and small residential customers, have two 18 baskets there instead of one, and apply your pricing 19 flexibility guidelines to those two baskets, you have 20 got the type of submarket definition and flexibility 21 you see being applied under this particular scheme. 22 MR. KING: Well, initially that's one 23 place where it would start, but let's presume at some 24 future date that, hypothetically speaking, the Board 25 declares revenue cycle services to be contestable so 26 that there now can be someone else who issues the bill, 27 collects the revenue, pays the distribution utility, et 28 cetera, et cetera. 503 OEB Panel 1 It might be the case that the Board 2 would wish to allow for certain type inflexibility in 3 certain segments of the contestable service to be able 4 to meet the market while enforcing certain, shall we 5 say, threshold pricing issues. For example -- 6 MR. HARPER: I understand the 7 response you gave to looking at the different functions 8 of utilities. 9 MR. KING: Okay. 10 MR. HARPER: I was cutting the 11 utility a different way by its customer classes -- 12 MR. KING: Yes. 13 MR. HARPER: -- in trying to 14 understand whether this flexibility meant that you 15 could subdivide your existing customer classes and have 16 pricing flexibility in terms of the prices you apply to 17 those subgroups of customer classes. 18 MR. KING: All right. Since it's not 19 so wise to do that. 20 MR. HARPER: Okay. I'm just trying 21 to understand the scheme and the reference to the words 22 that are being used in the term here. 23 I would like to turn to the area of 24 service quality standards now. As I understand both 25 the language in the report and the language I have 26 heard during the last day and a half here, the purpose 27 here is to set the minimum service standards that are 28 intended to sort of maintain service quality and then 504 OEB Panel 1 provide flexibility to distributors to try and do 2 better than that if they want to. Is that my general 3 understanding of what the intent behind these service 4 quality standards is? Is that correct? 5 MR. KING: That's correct. 6 MR. HARPER: During yesterday's 7 discussion with Mr. Power and Mr. Stephenson I think 8 later on today, you also indicated that in coming up 9 with these service quality standards there had been 10 data metric issues, data quality issues, sort of lack 11 of information on terms of what the customers really 12 wanted and that to a large extent you relied very 13 heavily on the task forces and the information you got 14 from the task forces in terms of coming up with this 15 sort of first generation PBR proposal for service 16 quality standards. 17 MR. KING: That's correct. 18 MR. HARPER: Within that context, 19 what I am having trouble understanding then is why for 20 new connections for LV -- low voltage new connections 21 your proposal is 100 per cent of the time for five day 22 connections whereas the task force itself only 23 recommended 90 per cent and what other information you 24 used to inform yourself that 100 per cent should be the 25 right number, particularly since we are talking about a 26 minimal standard here. A hundred per cent to me 27 doesn't sound minimal. 28 MS KWIK: I have to apologize. I 505 OEB Panel 1 think when I took the task force report and developed 2 this section of the report, I think I took the wrong 3 number along. 4 MR. HARPER: So it should be 90 per 5 cent? 6 MS KWIK: It should be 90 per cent. 7 Thank you. 8 MR. HARPER: Thank you. Roger, I'll 9 get there yet. 10 Would you agree with me that looking 11 at your menu option scheme that both customers and 12 shareholders will benefit to the extent that utilities 13 pick a higher ROE and a higher productivity factor 14 option. Maybe I can explain how I see that. 15 Customers benefit because they 16 benefit immediately. They are going to get the lower 17 rates because people are contracting for higher 18 productivity. The shareholder has the opportunity to 19 benefit because they have the opportunity to earn a 20 higher ROE. Would you agree that that's the case? 21 MR. KING: As long as you caveat the 22 last part with the opportunity. 23 MR. HARPER: Right, and believe me, I 24 recognize it is only the opportunity. 25 MR. KING: Because there is risk that 26 goes with it. 27 MR. HARPER: Yes. Would you confirm 28 that the feedback we heard from the September 2nd and 506 OEB Panel 1 3rd workshop suggested that the utilities that were 2 there seemed to suggest that they would -- all they saw 3 themselves doing is picking off the lower end of the 4 menu, maybe the first or second option. 5 I think some of the comments Dr. 6 Bauer made today sort of confirmed in his view -- his 7 comment was he couldn't see why anybody would go beyond 8 maybe the first option or so in sort of deciding which 9 menu option to pick. 10 Maybe it's better to take this in two 11 pieces. Generally it was my recollection from the 12 September 2nd and 3rd workshop there were a number of 13 comments of people saying that they didn't see 14 themselves picking anything higher than maybe the first 15 one or two options. 16 MR. KING: I think that there may be 17 a general understanding amongst the industry at the 18 moment that that's probably where they are leaning. 19 I'm not sure that that's necessarily where they wind up 20 after investigating a number of other issues into their 21 cost structure which they may not be fully thinking 22 about at the moment. 23 In particular, I think Dr. Cronin and 24 I would suggest that there are issues associated with 25 capital structure and the appropriate capitalization of 26 the utility. It does appear to us that there are a 27 number of MEUs that may be overcapitalized. 28 If one thinks about extracting some 507 OEB Panel 1 of that capital out, giving it back to the shareholder 2 or doing some other productive purpose with it, there 3 may be reasons to think about simply from those 4 standpoints, some level in the schedule beyond that. 5 Not only that, but again, the utility 6 does have an option of picking a different and higher 7 place in the schedule when they are in the midst or 8 when they complete a merger and amalgamation. 9 If you have substantial amalgamation 10 savings that might come about through that, then one 11 might choose a higher level. 12 MR. HARPER: No. I don't disagree 13 with anything that you are saying. I was just having 14 the concern that people looking at the scheme to begin 15 with seemed to say that with those caps, there was a 16 risk if they ran over the caps, there was no upside 17 gain. 18 I think, as Dr. Bauer noted, all 19 there was was downsize losses here in the sense there 20 was no lower end so that to contract up, you know, you 21 were sort of committing yourself to a higher 22 productivity level with sort of no protection at the 23 bottom. 24 That probably would be within your 25 initial read on this method. 26 MR. KING: I agree. That is an 27 issue. 28 MR. HARPER: Having said that, I 508 OEB Panel 1 guess I would ask what would be wrong with having an 2 earning sharing mechanism? Let me clarify what I mean. 3 I don't mean an earning sharing mechanism like Dr. 4 Bauer was talking about in terms of giving us some 5 downside protection. Put that aside. We will take the 6 downside risk. 7 I am talking about an earning sharing 8 mechanism simply to extend the sharing earnings over 9 and above the cap. It seems to me to the extent that 10 would encourage people to contract for higher levels of 11 productivity and higher ROEs, everybody would win and 12 the concerns about over-earnings could be addressed 13 through the sharing. 14 I would like to comment on what's 15 wrong with that particular approach. 16 MR. CRONIN: Could you just explain. 17 Specifically, you were saying it would get utilities to 18 choose higher productivity factors. 19 MR. HARPER: I think it has the 20 opportunity to get them to choose a higher productivity 21 factor because they realize that if they actually earn 22 over the ROE, if they actually go out and try and do 23 things and they earn over the ROE, they aren't going to 24 have to give it all back. They get to keep a portion 25 of it. 26 We can argue over whether the portion 27 should be 25 per cent or 75 per cent, but I think the 28 principle that earning sharing over the cap would 509 OEB Panel 1 encourage people to go out and pursue productivity 2 opportunities that they might not otherwise do if they 3 realized they had to give it all back. What's wrong 4 with that approach in a sense that the people who are 5 contracting up, and we have agreed that contracting up 6 higher on the menu is good for everybody. 7 MR. KING: Mr. Harper, we spent a 8 fair amount of time discussing what these risk 9 mitigation measures might be on the upper end, to 10 protect against the issues of over-earned earnings 11 because of potential errors that one might make in 12 constructing the plan. 13 Certainly we spent most of our time 14 discussing sharing mechanisms in the task forces. 15 However, the reason we arrived at this schedule or this 16 concept such as this was one of, for no better purpose, 17 they call it simplicity. 18 We were having difficulty being able 19 to explain how one might be able to have a schedule 20 where one could select a productivity factor, an 21 earnings cap that went along with that and then sharing 22 beyond it. 23 We believed that it was a real 24 difficulty in being able to communicate to many of the 25 folks in the industry with what that sort of mechanism 26 might look like, how they could understand it, touch 27 it, feel it, et cetera. 28 We don't necessarily have a problem 510 OEB Panel 1 with sharing if there is some way by which a sharing 2 scheme might be constructed in such a way that it is 3 more transparent to the industry. I think that the PBR 4 team is certainly willing to discuss it and believes 5 that it may have a fair amount of merit. 6 MR. HARPER: No, that's fair. Thank 7 you very much. 8 I only have two topics left. This 9 next one I almost dare to venture into on the IPI, but 10 I will go where doctors and economists have dared to 11 tread before. 12 MR. RODGER: Dared to assume before. 13 MR. HARPER: Thank you, Mr. Rodger. 14 I would like to turn to the September 15 16 material that you posted on your Web site, on the 16 Board Web site. I found that quite useful, looking at 17 sort of the history of the capital price index, the 18 labour price index, the materials price index and the 19 Consumer Price Index. 20 When I look at that, I draw some 21 conclusions from it and I would like to just share 22 those conclusions with you and see if you come up with 23 the same conclusions that I come up with. Do you need 24 a moment to turn the material up? 25 MR. KING: I have got it. 26 MR. HARPER: Okay. The first thing 27 is when I look at the labour price index and how it has 28 changed over the ten years, I see an average annual 511 OEB Panel 1 change of 2.72 per cent per annum which in my mind 2 isn't that far off the CPI at 2.65 per cent annum, I 3 mean less than a tenth of a percentage point per year. 4 To your conversations with Dr. Woo 5 about do those seem to track fairly well, my simple 6 arithmetic would seem to suggest yes. 7 I next look at the average labour 8 price index. Excuse me, I think it was the materials 9 was going up to 2.56 and the CPI 2.65. Like I said, 10 less than a tenth of a per cent difference. I didn't 11 see a lot of difference there. 12 I looked at the labour price index. 13 It was going up at 1.72 per cent per annum, again less 14 than a tenth of a percentage point per annum when 15 compared with the CPI. 16 So again, this issue about that the 17 CPI tracked the costs, just my simple mind in looking 18 at the 10 year average, there seems to be pretty close 19 correlation between labour prices, material prices and 20 CPI. 21 However, when I looked at the capital 22 price index, that was the place where sort of this 23 comparison stuff started to go awry. I think as you 24 mentioned, Dr. Cronin, the percentage change there is 25 substantially different than the CPI. 26 It is also substantially different 27 for the line losses, but I put that aside because going 28 forward line losses are going to be treated some other 512 OEB Panel 1 way and it is really just a capital index that is 2 important, if I understand this correctly. 3 Okay. So really on the issue about 4 CPI and tracking, it is really the capital index that 5 is the problem. 6 I then turned my mind to this issue I 7 had about volatility. I think I raised that during the 8 workshop. Again, I looked at the three indexes and in 9 my mind the materials price index is pretty stable in 10 its year to year changes; the labour price index is 11 pretty stable in its year to year changes. Again, the 12 capital price index was the one that seemed to be 13 introducing the volatility that we are concerned about 14 because of what it might do to rate stability. 15 So are my conclusions today -- sort 16 of my interpretations of the data correct? Would you 17 say that both from a CPI tracking point of a view and a 18 volatility point of view, it is really the capital 19 price index that is the one that is creating both of 20 the problems? 21 MR. CRONIN: I would agree with your 22 statements with the proviso that if you look at 23 individual one or two year changes that the CPI 24 deviates from all of the other indices that you 25 mention. Over a 10 year period the CPI and the price 26 of labour does in fact move pretty closely together and 27 you would expect that. 28 The problem is, you can even look at 513 OEB Panel 1 the data in the past three or four years in the CPI and 2 the wage rate data show significant year to year 3 differences. Over a longer period, those two certainly 4 move together very closely. 5 MR. HARPER: Okay. But then I turn 6 my mind to this capital price index and I tried to 7 understand what it was. Again I would like to give you 8 my layman's interpretation of it and you tell me if I 9 am correct. 10 The prices used to create this really 11 reflect current cost of capital. I have the current 12 Long Term Bond rate, I have a current price index for 13 the level of distribution investment. So this is 14 really a current price of capital is what is going into 15 the creation of this index. 16 I can understand that as being 17 important when somebody is making economic decisions 18 for new investment in a company, looking at what is the 19 current price of capital versus the price of labour, 20 versus the price of materials and coming up with the 21 most economic choice. 22 I also accepted as being sort of 23 maybe the appropriate price index to use if we were, as 24 I think it was Mr. Adamson was talking about, valuing 25 the assets and determining the rates of this entity 26 based on, you could say, I don't know what terminology 27 people use, sort of current cost accounting or 28 replacement value accounting, so that everything that 514 OEB Panel 1 was in the rate base as current asset values and 2 depreciation and interest were calculated accordingly. 3 Unfortunately, in my mind that is not 4 the way the system currently works. We have an 5 accounting cost which is based on imbedded costs; a 6 cost of debt which is based on a whole bunch of debt 7 issues that the utility may have borrowed over the last 8 20 years. What I have a problem with is, I don't think 9 this price index will actually track the capital costs 10 of the utility as reflected in the type of revenue 11 requirement that we have here now. 12 So that as this price index moves, I 13 don't think the capital costs that utilities will be 14 recording on their books will move accordingly. Would 15 you comment on that please? 16 MR. CRONIN: Well, let me just say 17 two things. 18 The first is that this index will 19 accurately track the changes in the cost for the 20 utilities -- 21 MR. HARPER: No, no. No, but that is 22 what I am fundamentally having a problem with. I can 23 see it actually tracking the changes in current costs 24 of capital for new capital decisions. 25 What I have a problem with is the 26 fact whether it actually changes -- the cost tracks the 27 capital cost structure of the utility as it is built 28 into the utility's rates. It is built into calculation 515 OEB Panel 1 of the ROE that this Board is going to go through at 2 the end of the day when it takes revenues minus costs, 3 comes up with net income and calculates and ROE for 4 this particular or any particular utility. 5 That is my fundamental problem and I 6 would like you to comment on it, please. 7 MR. CRONIN: I believe it tracks the 8 changes in the utility's cost. 9 MR. HARPER: So that if I have an 10 imbedded debt structure, which my utility does, 60 per 11 cent debt at an average imbedded interest rate, which 12 is not the same as the current cost of debt out in the 13 market, and if the current cost of debt goes up from 14 one year to the next by one percentage point from 7 per 15 cent to 8 per cent, my average cost of debt doesn't go 16 up that much. Similarly, if the Long Term Bond rate 17 goes down my average cost of debt doesn't go down by 18 that much. 19 This is the disconnect that I am 20 having with your index. 21 MR. CRONIN: Well, it reflects -- do 22 you want to -- 23 MR. KING: It is your choice to use 24 fixed price debt instruments. Another utility might 25 choose to use indexed instruments. 26 MR. HARPER: But I guess what I have 27 a problem with at any particular point in time is, the 28 choices I have are limited by past decisions and I'm 516 OEB Panel 1 not totally flexible to change all those decisions. 2 So to the extent the index change, 3 the costs don't change accordingly. I guess I was just 4 struggling with what was the appropriateness of this 5 particular capital price index. 6 MR. CRONIN: Well, it does reflect 7 the changes in the cost of the industry as well as the 8 opportunity cost applied to the industry by society. 9 Now, I think you and I had talked the 10 other day that in fact in the gas industry there is a 11 75 per cent passthrough of capital costs on a year over 12 year change. 13 MR. HARPER: No, that's on the ROE 14 side. 15 MS LEA: One moment, please. I'm 16 sorry. 17 Go ahead, Mr. Cronin. 18 MR. CRONIN: On the ROE side, the ROE 19 is directly connected to the price of capital. 20 MR. HARPER: Yes. 21 MR. CRONIN: We were talking about 22 ROE in the gas industry in cost of service, the 23 translation here is to the initial rates and the IPI. 24 I think this is something that we can definitely 25 suggest to the Board to consider this issue of capital 26 cost passthrough and what is an appropriate percentage 27 to passthrough. As I say, I think in the gas industry 28 they have chosen 75 per cent to apply. 517 OEB Panel 1 MR. HARPER: I think we are talking 2 apples and oranges here, but I'm not too sure. In the 3 interest of time I think we will address this through 4 our final submissions. I think I have the information 5 that I need and understand where you are coming from. 6 MR. KING: Mr. Harper, if I could 7 just maybe follow-up for half a second. 8 MR. HARPER: Sure. 9 MR. KING: Perhaps the other 10 mechanism of doing this would be to select an 11 alternative index, for example, the CPI which has no 12 capital cost component at all. I think the issue then 13 is that the firm is basically using capital. It is 14 attempting to raise capital. A significant portion of 15 the firm's cost structure is capital based and yet we 16 are selecting an index that has absolutely nothing in 17 it that reflects the capital. 18 MR. HARPER: That's right. I take 19 your point. 20 I guess where I was coming to in the 21 end was the conclusion in my mind that this wasn't a 22 perfect -- I mean, it may be a good index but this 23 wasn't a perfect index either. That is where I was 24 coming to at the end of my overall thinking and 25 understanding and going through sort of the various 26 pieces is that we have constructed an index here, it is 27 an attempt to track the costs of the utility but it is 28 not a perfect index in terms of matching up to the 518 OEB Panel 1 costs of the industry. I think we have heard lots of 2 discussion here that suggests no index will be a 3 perfect index in terms of tracking the costs of the 4 industry. Is that a fair conclusion to make out of 5 this? 6 MR. CRONIN Yes. There is no perfect 7 index. I think, though, if you look at the cost 8 structure that we have presented, and that Mike has 9 just alluded to, that 45 per cent of this industry's 10 capital, it is critical that you build that into it. 11 The second issue is that it would be 12 a lot easier if we were going to put in place a PBR for 13 10 years and everyone agreed that these deviations 14 between the indices will just net out over 10 years. 15 But in fact we are talking about a three year PBR where 16 any one of these indices, even the CPI versus price of 17 labour index can show significant differences within 18 that two or three year period. That is the concern 19 that we have. 20 MR. HARPER: I think we all have the 21 same concern in terms of seeking perfection when it 22 isn't there. 23 Those are all my questions. Thank 24 you. 25 MS LEA: Thank you very much, 26 Mr. Harper. 27 We have Mr. White and then Mr. Adams. 28 MR. WHITE: One of my questions was 519 OEB Panel 1 around the debt question as well. 2 Almost all the clients listed on my 3 list, in fact I think all of them, have recently 4 incurred substantive debt associated with expansions. 5 This debt is currently in long-term instruments. It is 6 a sunk decision and part of my question was going to 7 revolve around two aspects of that. 8 The one being the fact that if the 9 debt structure was above the imputed debt structure 10 what was going to be the implications of that -- the 11 debt level, I'm sorry. 12 The second was going to be as the 13 industry cost indices change. 14 If we are moving into a period of 15 higher interest expense, then maybe it will end up 16 leaving some of my clients a little more room. But if 17 we are moving into a period of lower interest expense, 18 they are not in a position to refinance their debt. 19 As such, I'm wondering if equity and 20 customer interest, from a price stability perspective 21 and other perspectives, are considered in this indicae. 22 MR. KING: With regards to the 23 leverage issue, the deemed leverage issues structure -- 24 or the capital structure that is represented in the 25 deemed structure applies no matter what the current 26 structure is of the firm. So if you leverage too much, 27 well, that's an issue, but that probably lowers the 28 cost to the consumer because your capital structure 520 OEB Panel 1 will be a lower cost capital structure. 2 With regards to the second issue -- 3 MR. WHITE: Assuming that the banks 4 don't increase the rate accordingly. 5 Okay. Go ahead. 6 MR. KING: The second piece of your 7 question which has to do with what happens if interest 8 rates drop and you have walked into higher cost of debt 9 instruments with no ability to exit them, well, that is 10 purely an issue of management. Management made the 11 decision to pursue that specific debt structure and you 12 bear the consequences of that. 13 MR. WHITE: Those decisions were made 14 before the rules were in place. 15 MR. KING: I think that every utility 16 should bear some responsibility for the decisions that 17 management make. So, c'est la vie. 18 MR. WHITE: Maybe we can go back to 19 some of the other issues. 20 Incidentally, do you agree with those 21 statements, "c'est la vie"? 22 MR. CRONIN: You know, if I 23 understood French -- 24 --- Laughter 25 MR. WHITE: It's life. Go ahead. 26 MR. CRONIN: Oh. It's life? 27 MR. WHITE: That's life. 28 MR. CRONIN: Oh, that's life. Oh, 521 OEB Panel 1 that's life. 2 Well, he has kind of a -- I think 3 this question was the kind of a free market, roughian 4 attitude, so I wouldn't disagree with a free marketeer. 5 No, I agree. I think the point is 6 that what we are trying to do in the PBR is to shift 7 more responsibility to management and that they are 8 going to be facing these exact questions going forward 9 on a more pervasive basis. 10 MR. WHITE: I don't have nearly the 11 problem with going forward as I do with the problem 12 going backward. I would ask Ms Kwik to remember her 13 words that they are no worse off under the old 14 regime -- or the new regime than they are under the old 15 one in considering this kind of situation. 16 With respect to a minimum bill, in 17 the early September session I raised a question about 18 minimum bills as it relates to significant capital 19 expansions for large customers. When I raised the 20 question I wasn't thinking about minimum bills for 21 residential customers because, assuming that we have a 22 reasonable and equitably priced service charge, if the 23 service is available -- I don't care whether you call 24 it a service charge, a customer charge, whatever you 25 want to call it -- if that is available, if the service 26 is available, then the cost is probably there. 27 My question dealt more with the 28 situation where the utility is obliged to make 522 OEB Panel 1 significant capital expenditures and the service charge 2 may reflect "a normal ongoing situation" but not be 3 adequate to cover the significant capital investments 4 that might be made to serve a large industry. 5 Traditionally, there has been some recognition of that 6 based on the demand that these large customers might 7 impose on the system and an ongoing minimum bill that 8 extends out I think for Ontario Hydro's direct 9 industrial customers five years. 10 So my question is: Is that kind of 11 contractual relationship for the sharing of risk over 12 significant capital investments precluded by the price 13 structure that is in place? It appears to be. 14 MR. KING: I think that these issues 15 really are probably more the subject of a forthcoming 16 document from the Board and the Board staff, which is 17 the system and facility expansion guidelines. 18 MR. WHITE: I guess if everything is 19 going to be 100 per cent paid for by somebody other 20 than the shareholder or the utility -- and I might take 21 some huge comfort in those words that you just said, 22 but if there is going to be an expectation of some 23 recovery from the rate level, then the pricing 24 mechanisms that are put in place must reflect that 25 recognition. 26 MR. KING: I agree. Those have to be 27 taken into -- would be taken into account in that 28 document that I just referred to. 523 OEB Panel 1 MR. WHITE: Okay. I will look 2 forward to seeing it, then. 3 I noticed in the unbundling model, 4 and I guess I'm kind of sorry Mr. Harper has left, that 5 there is a reliance that the utility's existing 6 distribution costs are what their base costs are and 7 will be. There doesn't seem to be any contemplation 8 that Ontario Hydro Services Company or others might 9 levy charges for sub-transmission lines that serve 10 utilities which may not have a transformer station 11 within their boundaries. 12 MR. KING: No. I think those would 13 be deemed as transition costs. Anything that changes 14 that is not in current rates I think you can bring 15 through the transition mechanism. 16 Also, all the issues associated with 17 transmission pricing and how it flows through are being 18 handled in the retail settlement system right now and 19 are outside of the PBR mechanism. 20 MR. WHITE: All of the transmission? 21 MR. KING: Yes. 22 MR. WHITE: Good. Thank you. 23 I have a question on the service 24 quality indices that were put forward. I didn't see 25 any indication of causality in the indices, in other 26 words, whether they were caused by the utility's plant 27 or by the supply side. 28 MR. KING: No. I think there is a 524 OEB Panel 1 specific code for that. 2 MR. WHITE: Okay. 3 MR. KING: It is the intent that when 4 you calculate SAIDI, CAIDI and all the reliability 5 mechanisms, they actually both calculate it two ways. 6 This may not be specific in here but you calculate it 7 two ways: one, with those loss of supplies that are 8 not attributable to the utility and one without. 9 MS LEA: I'm sorry. I have to 10 interrupt for a moment. 11 Did you say "SAIDI, CAIDI"? I didn't 12 hear those and I'm sure the reporter doesn't know how 13 to spell them. I gather they are acronyms. 14 MR. KING: SAIDI, that's S-A-I-D-I, 15 that is "D" as in David; CAIDI, C-A-I-D-I; and SAIFI, 16 S-A-I-F-I. 17 MS LEA: Those are all in capitals, I 18 gather, because they are acronyms? 19 MR. KING: That's correct, they are 20 acronyms. 21 MS LEA: Thank you. 22 MR. KING: If you look at Table 5-2 23 on page 5-6 there is a code called 1 -- excuse me -- 24 code 2 which is a loss of supply. 25 MR. WHITE: Okay. 26 Can you help me a little bit, then. 27 When Ontario Hydro Services Company is reporting a 28 problem on their system that results in a loss of 525 OEB Panel 1 supply to a utility, are they reporting all of the 2 customers in the utility or are they reporting one 3 customer as being out of power, i.e. the utility? 4 In other words, is the question 5 end-use customers that are put -- 6 MR. KING: You mean when they are 7 downstream of an Ontario Hydro distribution system? 8 MR. WHITE: Yes. What does Ontario 9 Hydro report? 10 MR. KING: I don't think that we had 11 specifically determined what they should report. That 12 certainly wasn't in the rate handbook. 13 It seems like what they should report 14 is all of the customers of the affected distribution 15 utility -- 16 MR. WHITE: I couldn't agree more. 17 MR. KING: -- so that they don't just 18 count them as one. 19 MR. WHITE: I couldn't agree more. 20 MR. KING: Otherwise, I think it 21 would seem to indicate that fewer customers were really 22 affected than were really affected. 23 MR. WHITE: I'm pleased to hear that. 24 Thank you. 25 --- Pause 26 MR. WHITE: One more question: 27 Contributed capital. We all seem to want to run around 28 the horn on this one a little bit. 526 OEB Panel 1 If a utility had chosen in the 2 past -- pre-Bill 35 and pre the PBR handbook -- to fund 3 all of its expansions and all of its new acquisitions 4 from rates, would those rates be higher or lower? 5 MR. KING: You mean that -- 6 MR. WHITE: That the end use 7 customers would -- 8 MR. KING: -- it would basically 9 raise debt and try and recover the expansion through -- 10 MR. WHITE: No, no. No, no. 11 MR. KING: Historically. 12 MR. WHITE: Historically they funded 13 them out of rates, net income, retained earnings, 14 whatever we want to call it, they funded all of their 15 expansions out of that, they were able to get the rates 16 past the regulator and high enough that instead of 17 taking capital contributions from customers -- 18 MR. KING: Higher. 19 MR. WHITE: Okay, good. Thank you. 20 Then under PBR they are allowed to 21 carry on with higher rates than the identical utility 22 down the road that took 50 per cent contributed 23 capital? 24 MR. KING: I think that is the impact 25 of the staff's proposal. 26 MR. WHITE: Thank you. 27 I think I heard you both saying that 28 a recognition of the true cost of capital going in 527 OEB Panel 1 which might best be reflected at market value was a 2 better economic signal -- I have to be careful where I 3 go, I'm over my head a little bit -- so that from an 4 overall efficiency, economic efficiency perspective, 5 allowing the market return to the contributed capital 6 would be a better mechanic than trying to allow either 7 zero or some other number? 8 MR. CRONIN: Right. I think the only 9 thing I would add to that is that we are sort of 10 assuming away the potential overcapitalization issue. 11 MR. WHITE: I understand that. 12 MR. KING: The other thing I would 13 add to that is largely an issue of fairness in my mind, 14 because there were certainly not simply management 15 issues that led to some utilities having a zero or 16 negative return and others having a positive return. 17 There were also regulatory actions that were taken by 18 Ontario Hydro related to working off working capital 19 balances that may have been surpluses and as a result 20 they may have had negative or zero ROEs, as I 21 understand it, from the previously regulatory 22 framework. 23 So if they chose to use contributed 24 capitals a firm could -- while I think the intent of 25 the staff's proposal was that they would receive what 26 their expectation was, in this case their expectation 27 was being, in part, tempered by an external force 28 completely outside of the realm of decision-making of 528 OEB Panel 1 that managerial body. 2 So it seems to me to not be quite 3 fair to have utilities in two different circumstances, 4 one of whom receives a positive return on contributed 5 capital and one who receives nothing. 6 MR. WHITE: What happened to "c'est 7 la vie"? 8 --- Laughter 9 MR. KING: I think that was Dr. 10 Bauer's -- 11 --- Laughter 12 MR. WHITE: In the absence of fair 13 market return on contributed capital, is it fair to 14 characterize the consultant's view that a common rate 15 of return on contributed capital, a universal one 16 number applied universally is a preferred option? 17 MR. KING: Yes. That might be zero, 18 it might be the market based rate of return, it might 19 be some other number, but -- 20 MR. WHITE: Thank you. 21 MR. KING: -- it seems like it should 22 be at least consistent. 23 MR. CRONIN: It is better 24 theoretically and from a practicality perspective. 25 MR. WHITE: Thank you. 26 No more questions. 27 MS LEA: Thank you, Mr. White. 28 Mr. Adams? 529 OEB Panel 1 MR. ADAMS: Thank you. 2 I have some questions I might 3 characterize as trees questions and then some forest 4 questions afterwards. 5 With regard to your sample of the 48 6 utilities that provide you with data, would you agree 7 that you don't have a random sample of the experience 8 with MEU costs in Ontario? 9 MR. KING: They were not selected 10 randomly. 11 MR. ADAMS: They were in fact 12 self-selected. Is that correct? 13 MS LEA: I'm sorry, that answer 14 wasn't heard. 15 I believe the answer was: They were 16 not selected randomly. 17 THE COURT REPORTER: Thank you. 18 MR. KING: But they were not 19 necessarily self-selected either. 20 Why don't you describe the selection 21 process? 22 MR. CRONIN: Yes. We sampled all of 23 the large utilities, we ultimately sampled about 24 two-thirds of the medium and about 8 per cent of the 25 small. 26 Now, with respect to the small ones 27 there was no preordained approached. We basically 28 screened what came in and took about 16 of the 530 OEB Panel 1 utilities for whom we had gotten an update from them 2 that we felt we could complete the datasets. So it 3 wasn't -- in that sense I'm not sure if it's -- I can't 4 tell you if it doesn't -- I don't know if it represents 5 the rest of the 200 small utilities. I don't have any 6 reason to believe that it is not representative. 7 MR. ADAMS: Well, let me understand 8 this better. You asked a bunch of detailed questions, 9 some utilities might not have had the answers at hand. 10 MR. CRONIN: Some didn't. 11 MR. ADAMS: Some did not. 12 MR. CRONIN: Right. 13 MR. ADAMS: And some did and they 14 provided those to you. Right? 15 MR. CRONIN: Yes. 16 MR. ADAMS: Now, would you expect 17 that the better managed utilities would have data at 18 hand rather than being amongst those group of utilities 19 that didn't have the data that you were requesting? 20 MS KWIK: Actually, part of that in 21 any case. When we did get responses from the 22 utilities, they called to tell us that some of them had 23 a policy of not keeping the data for longer than four 24 years. 25 MR. ADAMS: Does that sound like good 26 management practice to you, one of the largest 27 utilities in the province claiming they could not 28 produce data for anything more than the last six 531 OEB Panel 1 months? 2 MR. KING: Well, no. It possibly 3 could be good management process. 4 MR. ADAMS: How is that? 5 MR. KING: Who needs data from 15 6 years ago other than the Regulator at the time that 7 they are thinking about a regulatory change? Who 8 knows? Maybe this was a strategic decision by them and 9 it was very apropos that they made it. I don't know. 10 That was tongue in cheek. 11 You know, the issue is for what 12 purpose are the data older than, say, four years being 13 maintained? With some of the information systems, some 14 utilities have chosen to implement new accounting 15 software, new billing platforms. As a result, the data 16 just simply were not retained subsequent to those sorts 17 of periods. 18 MR. CRONIN: Maybe to pick up. We 19 did observe within the 15 small utilities that we 20 completed the analysis for. By the way, amongst some 21 of these responses were some of the best datasets that 22 we did get. 23 We did observe, as was documented in 24 the Staff Report, that their costs were below the 25 medium and large, that the range of cost experiences 26 was narrower than the medium and large and that their 27 rate of productivity improvement was above the medium 28 and large. 532 OEB Panel 1 Now, you know, your hypothesis that 2 maybe they are the better managed firms is an 3 interesting hypothesis. It certainly was something 4 that we had mentioned among ourselves. We did observe 5 that they had done very well from a performance 6 perspective. 7 MR. ADAMS: It just occurs to me that 8 if this is true, then the estimates you have made about 9 productivity opportunities may be in fact 10 underestimated. 11 MR. CRONIN: Yes. Exactly, and 12 particularly if you look at the small utility 13 experience, they certainly were not doing worse than 14 the other utilities. 15 MR. ADAMS: This is something that I 16 was going to get into later. I think it's important to 17 note that some of the better managed utilities don't 18 happen to be the biggest ones. Is that correct? 19 MR. CRONIN: Exactly. It would seem 20 from the data that that's true. 21 MR. KING: That may be true and 22 that's in fact one of the attributes that we found of 23 the plan design after the fact when it's all done and 24 you start thinking about some of the implications of 25 what it is that has been designed. 26 One of the implications that came to 27 us after the fact was that by designing a plan that's 28 one size, we aren't making a judgment on whether there 533 OEB Panel 1 are economies of scale or diseconomies of scale. 2 Instead, the plan will reward those to whom are the 3 most efficient. 4 If they can find economies of scale 5 by having a good management team from the small utility 6 and acquiring medium and large utilities so that there 7 are merger savings and management efficiencies that can 8 be driven in, the plan will reward them for doing so. 9 MR. CRONIN: Can I make a comment? I 10 won't claim that I thought of this comment, but someone 11 mentioned to me a few weeks ago after looking at the 12 data on the small utilities that maybe they were the 13 ones that should do the acquiring. 14 MR. ADAMS: In fact, in aid of this 15 point I will quote you. I won't turn you to the page. 16 I think I can read it. If you want it, it's from 17 Toronto Hydro's first submission, page 5. Toronto 18 Hydro says in paragraph 14: 19 "For example, the average medium 20 utility could easily achieve 21 option A --" (As read) 22 The lowest level. 23 "-- with no additional effort. 24 On the other hand, the average 25 large utility must stretch 26 itself to increase productivity 27 by almost 1 per cent just to 28 meet the minimum PF of 1.25. 534 OEB Panel 1 This is overly aggressive and 2 punitive to shareholders of 3 large and small utilities." (As 4 read) 5 One reading of this statement is that 6 Toronto Hydro would be more efficiently arranged in 7 smaller utilities. Is that correct? 8 MR. CRONIN: Well, you can't -- can I 9 say three things about -- let me say three things about 10 the statement and then pick up on your conclusion. 11 You can't risk the conclusion you 12 reach basically data that will be produced. I think 13 they -- 14 MR. ADAMS: Let's accept Toronto 15 Hydro's statement on its face. 16 MR. CRONIN: Their statement I think 17 confuses the level of productivity with the change in 18 productivity and they assert that the average medium 19 utility with no additional effort could reach the 20 target. What the target is is 1.25 per cent 21 improvement per year and what we showed was that based 22 on the 48 sample that the medium utilities were 23 improving at 1 per cent a year, but they still have to 24 improve at 1 per cent per year. 25 That is if they stop improving, they 26 miss the target. Now, in fact the data for the large 27 utilities, because this is an unweighted -- well, even 28 though it's unweighted, the data is heavily affected 535 OEB Panel 1 upon the large utilities by an extreme outlier. In 2 fact, if you looked at the five year period that we did 3 recently produce data for, the medium and large 4 utilities are almost exactly equivalent in terms of 5 their five year performance at around 2 per cent as 6 compared with the smaller utilities that are at 2.4. 7 In fact, there is no difference in 8 performance over the more recent five year period which 9 we in fact on reflection think is by far the better 10 comparison period. 11 MR. ADAMS: With the extreme outlier 12 left out. Is that the analysis you just referred to? 13 MR. CRONIN: No. They were still 14 included. 15 MR. ADAMS: Still included. 16 MR. CRONIN: Right. 17 MR. KING: So there was an event in 18 the early part of the period that caused the effects on 19 the entire period. 20 MR. ADAMS: So that maybe the rate 21 freeze. 22 MR. KING: No. I think with that 23 utility there were some issues that were going on in 24 terms of capital renewal in the system in a series of 25 large progress that they had. 26 MR. ADAMS: To pick up on your point. 27 Really what the menu does is to say to the average 28 utility that the default value is about 60 per cent of 536 OEB Panel 1 the average improvement that we have seen over the past 2 five years. 3 MR. KING: But to come back to your 4 original premise, does it suggest that one should break 5 a utility up? Well, if there are diseconomies of scale 6 that are truly there, and Toronto Hydro could achieve 7 higher productivity growth by, for example, breaking 8 itself up into a series of business units that operate 9 somewhat autonomously with independent management, they 10 would have the incentive to do so. 11 I think from that point of view the 12 plan allows the industry to find the optimal scale. We 13 will see what the results should be. 14 MR. CRONIN: But we did not do any 15 analysis that would allow one to draw a conclusion 16 about economies of scale. 17 MR. ADAMS: Understood. 18 MS LEA: Mr. Adams, sorry to 19 interrupt you. It's unfortunate and it's not your 20 fault, but we are at six o'clock now. I think that we 21 can probably give you a few more minutes but to go 22 beyond ten past six on that clock would verge from 23 discourtesies to the reporters to abuse, so I'm afraid 24 I can't keep them longer. 25 Now, we can bring Ms Kwik and 26 Dr. Cronin back. Mr. King will not be available after 27 today. If you have questions, therefore, that you 28 think are best directed to Mr. King, I wonder if you 537 OEB Panel 1 could take five minutes and ask those now and then we 2 will have to stand this panel down and complete it at a 3 later time. 4 MR. ADAMS: I have no specific 5 questions to direct to any specific witness. I want 6 the panel all to feel free to reply. I apologize to 7 the panel for keeping you late. 8 MS LEA: It's not your fault, 9 Mr. Adams. It's just the way the day went. 10 MR. ADAMS: Now, there are utilities 11 that made a public reputation for themselves according 12 to their efficiency by comparing their gross margin 13 versus the gross margin of other utilities, but this 14 approach is rather superficial because it doesn't 15 reflect on contributions made and there's a variable 16 policy from utility to utility. 17 How did your productivity assessments 18 deal with this revenue splitting issue? 19 MR. CRONIN: Revenue only comes into 20 the analysis in terms of helping us provide weights for 21 our output measures which are connected customers. 22 Now, if you are asking about the contributed capital 23 issue, is that -- 24 MR. ADAMS: No, just in terms of the 25 total utility revenue is the sum of their rates, plus 26 their contributed capital. In any assessments that you 27 are making about productivity that relate to revenue, 28 you would have to accommodate both those revenue 538 OEB Panel 1 streams. Do you agree? 2 MR. CRONIN: I think maybe our 3 approach is a little bit different. We are not 4 interested in revenue except to the extent that it 5 gives us a weight in order to sum up the connected 6 customers. 7 The contributed capital issue comes 8 into play when we want to define the amount of capital 9 that is going into the production process, so we want 10 to include all forms of capital, as we do all forms of 11 inputs. We want to include all classes of connected 12 customers. It's a comprehensive representation. 13 MR. KING: Mr. Adams, maybe if I 14 could just spend half a second to explain just slightly 15 differently. 16 Here we are measuring output as the 17 number of connected customers, but a residential 18 customer is not perhaps the same as a large use 19 customer. We have to find some way of saying what is 20 the -- you know, you can't just add them all up. 21 Instead, you have to be able to control for the fact 22 that you may have more large use customers over time 23 relative to residential customers and the way that that 24 has been done is to use the revenue weights in order to 25 construct the output measure. 26 MR. ADAMS: I just want to close my 27 questions in this area of productivity by asking 28 whether some of the data that you would have liked to 539 OEB Panel 1 have had in this analysis is in the possession of OHSC 2 and whether OHSC was requested to provide the data and 3 whether they provided the data. 4 MR. CRONIN: Could I just ask you to 5 elaborate? 6 MR. KING: I think that the short 7 answer to the question is that we needed data beyond 8 that which was in the possession of OHSC in order to do 9 the analysis. Even though certain of the data, for 10 example, debt that resides in the mud bank or -- I get 11 these things somewhat confused. While some of that 12 data may have been somewhat useful, we did believe that 13 we needed to go a little bit further than that, as Mr. 14 Adamson has pointed out, and to construct, for example, 15 a 20 year capital stock and obtain other pieces of data 16 that required -- that were not in the possession of 17 OHSC. 18 MR. ADAMS: So you had full access to 19 OHSC data and that was deficient or -- 20 MR. KING: Actually, we did not have 21 full access to OHFC's data until after April 1. 22 MR. ADAMS: Why is that? 23 MR. KING: It wasn't provided to us. 24 MS KWIK: Just to clarify, are you 25 referring to the data that Ontario Hydro had for the 26 MEUs or are you talking the data -- 27 MR. ADAMS: That's correct. 28 MS KWIK: Oh, okay. 540 OEB Panel 1 We had data available to us that was 2 from the MUD bank, but as Mike and Frank said it wasn't 3 sufficient. We needed more than what was in that. 4 MR. CRONIN: We only had four years. 5 At that point, this is during the winter, we only had 6 four years of MUD bank data, and what we had was not 7 comprehensive enough to provide the information we 8 needed. 9 MR. ADAMS: Did OHFC fully co-operate 10 with you on this? I'm surprised that there are only 11 four years of data. 12 MS KWIK: There was a problem that 13 they had four year's worth of data available 14 electronically that was accessible. The rest of it was 15 in a database for which there was no longer a system 16 that could bring it out to us. 17 MR. ADAMS: Is it true that OHSC 18 asked you to pay for the data? 19 MS KWIK: No. 20 MR. ADAMS: Okay. I will leave off 21 that area of questioning and ask about service quality 22 indicators. 23 MS LEA: I think we may have to 24 close. Mr. Adams, we are very happy to bring the panel 25 back for you. We don't want to limit your questioning 26 at all. But I think time unfortunately has run out for 27 us, unless you figure you can finish in about three 28 minutes and I trust that you wouldn't limit yourself. 541 OEB Panel 1 MR. ADAMS: I cannot. 2 MS LEA: Okay. That's fine. 3 We will have to, then, stand this 4 panel down further. 5 One administrative matter. 6 Yesterday I indicated to Mr. Power 7 that we would check into some information referred to 8 by Ms Kwik on the stand. 9 We have done that. A copy has been 10 provided to Mr. Grieve for a quick reference. However, 11 it was not new information, it was information in the 12 possession of members of the task force for months, I 13 believe. 14 If you need anything further, 15 Mr. Grieve, you can get back to us on the details of 16 that. 17 MR. GRIEVE: Thank you. 18 MS LEA: I would like to thank 19 Mr. King very much for his attendance on the panel here 20 over the last few days. We really appreciate it. 21 Dr. Cronin, you will get your thanks 22 I guess when you are done, but, yes, thank you to all 23 of you. 24 --- Laughter 25 MS LEA: Mr. Adams, could you speak 26 to me about when it is convenient for you to continue 27 your cross-examination because I think we can 28 accommodate your schedule there. 542 1 MR. ADAMS: It's not 2 cross-examination. It's just clarification. 3 MS LEA: It's part of me. Yes. I'm 4 sorry. I'm so used to hearings. Questions. Thanks. 5 MR. WHITE: Can you give us an 6 updated forecast at this point? 7 MS LEA: A forecast on what, sir? 8 MR. WHITE: Schedules. 9 MS LEA: Well, if we look at 10 Thursday, it looks like Thursday can proceed as listed, 11 at least I hope so. 12 On Friday, the original schedule can 13 proceed as listed also, the first two presenters. 14 I think then we would be looking at 15 hearing from Pollution Probe and ECMI at that point. 16 As I say, I will speak to Mr. Adams about when we might 17 bring the staff panel back to complete his questioning. 18 On Monday we will have John Todd from 19 the Vulnerable Energy Consumers Coalition. He is 20 starting at 9:00 a.m. on Monday. 21 So we will see you at 9:00 a.m. 22 tomorrow. 23 Thank you. 24 --- Whereupon the hearing adjourned at 1808, 25 to resume on Thursday, September 23, 1999 26 at 0900 27 28 543 1 INDEX OF PROCEEDINGS 2 PAGE 3 Preliminary matters 259 4 OEB Panel resumed 260 5 Questions by Mr. Adamson 260 6 Questions by Mr. McKerlie 303 7 Upon recessing at 1036 321 8 Upon resuming at 1100 321 9 Presentation by Nepean Hydro Panel 323 10 Questions by Ms Kwik 339 11 Questions by Mr. Adams 340 12 Questions by Mr. Cronin 348 13 Questions by Mr. King 349 14 OEB Panel resumed 351 15 Questions by Mr. McKerlie 351 16 Questions by Mr. White 362 17 Questions by Mr. Emmet 384 18 Luncheon recess at 1246 388 19 Upon resuming at 1344 388 20 CAC Panel 388 21 Questions by Mr. Warren 388 22 Questions by Mr. Rodger 402 23 Questions by Mr. Grieve 409 24 Questions by Mr. Adamson 410 25 Questions by Mr. Gibbons 424 26 Questions by Mr. Stephenson 430 27 Questions by Ms Demarco 438 28 Upon recessing at 1513 445 544 1 Upon resuming at 1534 445 2 Questions by Mr. Faye 445 3 Questions by Mr. Cronin 453 4 Questions by Mr. King 457 5 Upper Canada Energy Alliance Panel 459 6 Questions by Mr. Rodger 474 7 Questions by Mr. Gibbons 477 8 Questions by Mr. McKerlie 479 9 Questions by Mr. Poch 481 10 Questions by Mr. Cronin 483 11 Questions by Mr. King 488 12 Questions by Ms Kwik 493 13 Questions by Mr. White 494 14 Upon recessing at 1655 497 15 Upon resuming at 1707 497 16 OEB Panel resumed 497 17 Questions by Mr. Harper 497 18 Questions by Mr. White 518 19 Questions by Mr. Adams 528 20 21 22 23 24 25 26 27 28 545 1 EXHIBITS 2 3 NUMBER DESCRIPTION PAGE 4 5 A Package referred to 496 6 by Board staff in its 7 opening statement 8 9 B Package submitted by Upper 496 10 Canada Energy Alliance 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 546 1 UNDERTAKINGS 2 3 An undertaking can be found at page 438 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28